Beginning to Think Psychologically

The reason I began The Schott Letter almost 26 years ago was to help investors for whom the investment process was foreign and anxiety provoking. It has been a gratifying journey when readers and others write me or call to say that I have been a genuine help to them. Most realized that they were not behaving rationally, but they could not find any writings to validate their thinking and experience.

For most people the investment process is not an ordinary part of their life experience. As children they were taught little about it. In fact, in the preponderance of cases children were systematically excluded from any knowledge of parents' investments and from their financial life totally. This is not a surprise considering the tremendous amount of affect surrounding money.

From a psychoanalytic viewpoint, these early and often primitive attachments relate to the anal period of development and are therefore often highly conflictual. More recent psychoanalytic theories related to the psychology of the self take the genesis of the feelings about money to even earlier stages of development. This theory means that the adult awareness of conflicts over money occurs almost exclusively in the non-verbal mode of affect and not through thought. Thus when an adult makes a major investment mistake, his or her experience is a sense of lost self-esteem and the resultant depression is far greater than the real extent of the loss of money or property.

Every drive associated with money gets played out in investing—the longing for security, the guilt associated with greed, the search for love, the desire for greater self-esteem, the quest for power, and the fantasy of omnipotence. In truth, for all but the extremely rare investor, emotions are the entire ball game. It is safe to say that every published investment system has as its main goal the elimination of emotions from the investment process.

Panic

When our emotions gain sway, we are very likely to lose money even in a bull market. Peter Lynch managed the Fidelity Magellan Fund from 1978 through 1992. During his tenure, the Magellan Fund compounded its NAV (Net Asset Value) at 30.1 percent a year. That means that an investor in Magellan saw her or his money double at the rate of every two years and four months. If you had invested $25,000 in 1978, it would have grown to $1,200,000 by 1992. (Of course this would have been diminished by taxes so the actual after-tax amount would have been about $775,000.) Yet, the average investor in Magellan during that period lost 12 percent! This occurred because many Magellan investors bought their shares after hearing about the fund's fabulous performance only to experience an air pocket when the fund took a temporary drop. Panic set in and the average investor sold after being a shareholder less than six months.

Investing can and should be a rewarding endeavor. Good investing is not only financially rewarding but psychologically rewarding as well. In a free market in a growing country, as the U.S. has been throughout its existence, the odds are overwhelmingly in favor of the long-term investor making solid profits.

Going back to 1893, there have been two times when a long-term investor would have done poorly. The first of those times was for people staring their investment program in 1928 or ‘29; the second was for people starting in 1972 or ‘73. (If I am still writing in 2030, I might be forced to add a third bad starting point which would be 2000 and 2001.)

The critical aspect of this is for an individual to act as an adult, investing based on knowledge of the investment process and knowledge of the companies in which she or he invests. If you lack the necessary knowledge, the best starting place is to read Benjamin Graham's great book The Intelligent Investor. Step one in your reading is to learn the difference between investment and speculation. A high percentage of individual investors speculate rather than invest. They buy on rumors not facts and chase high fliers rather than seeking to buy low and sell high.

Mr. Market a Manic Depressive

Graham's chapter entitled “Mr Market” will give you additional insight into the psychological nature of the stock market. In that chapter, Graham describes a situation in which you have partnered with a friend in a very ordinary business, let's say a hardware store. The store becomes locally popular and you and your friend are delighted with its prospects. You know from first-hand knowledge that the store is worth about $2 million. It turns out that your friend, whom Graham named Mr. Market, is given to mood swings that can be severe. So one day he arrives at the store almost euphoric and makes you a $2.5 million offer for your half of the business. Although you love owning the store, you sell it to him because you know your half is really worth only $1 million. On another day he comes in almost morose and declares he wants out and offers to sell you his share for only $200,000. Immediately you whip out your checkbook and buy his share.

Graham says this is the way the whole market is, the way a given sector may be, and how a particular company might be. In other words, the market has an essentially manic-depressive quality. This should not surprise any of us because the market is an expression of a collection of individuals who are psychologically driven.

The only surprise in all of this comes from the fact that since the 1950s, the world's leading economists have subscribed to a different theory called the efficient market hypothesis (EMH) in which it is believed that in a free market a security will always reflect all that is known about that security. In spite of overwhelming research data to the contrary published in the last 20 years, the economics departments still teach the EMH. This simple error provides individual investors with a ready opportunity to outperform the markets.