Investors who experienced the crash in 2009, or the rally in equities in 2013, know how challenging it can be to separate reason from emotion. Keeping emotions at bay when the stock market rallies and everyone else is excited is not easy.
When a rational process has been set in advance, it is easier to make logical decisions in the heat of the moment.
Why is it so difficult to govern our emotions? We have two systems at work in our brains: the rational and the emotional. Understanding the ways these systems interact can shed much light on an investor’s decision-making process. A helpful metaphor is that of the rider and elephant, first introduced by Jonathan Haidt in The Happiness Hypothesis: Finding Modern Truth in Ancient Wisdom. The rider is your rational system and the elephant is your emotional system. Thoughtful and logical, the rider is the one who ought to be in charge. But the elephant is a force; if driven by strong feelings of fear, hubris and greed, it can easily ignore the rider’s sensible instructions.
The elephant and the rider analogy helps illustrate why prudent risk-taking can be such a difficult task for an investor. It highlights why many investors found it difficult to invest in equities in 2009, even if the case was compelling from a risk-return perspective, and why investors may find it difficult to be prudent when the market’s temperament towards risk becomes dismissive. But the difficulty of taming the elephant does not mean this task is impossible. There are strategies investors can use to control their emotions’ influence.
In the 40 years Mawer has operated as an investment manager, we have found that the best strategies all seem to have one thing in common: a systematic process. When a rational process has been set in advance, it is easier to make logical decisions in the heat of the moment. It may be boring, but it is easier to ignore the volatility in the market when your process does not rely on watching the market every single day.
There will be ample opportunity in the future for investors to test their own emotional control. Having a predefined process is one of the best ways an investor can avoid getting swept up into the herd of elephants that is the emotions of the market.