Extreme emotions, such as fear and greed, have a corrosive effect on the quality of investment decision-making. This is a theme in Warren Buffett’s periodic pronouncements.
In his 1986 Chairman’s Letter, Buffett wrote: “[We know] that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
In his 1990 letter, Buffett wrote: “The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.”
Buffett has said that a key to successful investing is the ability to control the urges that get other investors into trouble. But exactly how are you supposed to control these dangerous urges? Buffett is largely silent on the matter.
Most folks in the investment industry recognise that when you allow yourself to be overwhelmed by extreme emotions, you will fall prey to the urges. That’s not good. Therefore, it seems to follow that you should try to suppress your emotions out of existence, so that you can be a super-rational decision-maker. This seems to be the only alternative.
However, I believe that you will get far better results with a less binary approach, one that is built on deeper awareness of emotions rather than flat denial of emotions. This might even serve as a decent definition of investment discipline:
- Your Emotions. You are aware of your own emotions and you can manage these emotions effectively.
- Others’ Emotions. You are aware of others’ emotions and the actions they are likely to take while in the grip of these emotions.
- Your Actions. You are able to translate your awareness into action (or mindful inaction) that’s consistent with the design of your investment process.
Before you can follow your investment process with any consistency, you need to be able to control dangerous urges. Before you can control dangerous urges, you need to be able to manage your emotions. In order to manage your emotions, you need to be aware of your emotions. And, in order to exploit others’ emotional excesses in the markets, you need to be aware of their emotions.
By definition, denial of emotions pushes them out of awareness. This makes the emotions unmanageable, potentially rebellious, and ultimately hostile to investment discipline. That’s the precise opposite of what you want. Conscious awareness of emotions is a far better option than flat denial.
The number-one enemy of conscious awareness is noise. I define noise as the set of acute disruptions and chronic disturbances that undermines the conscious and constructive deployment of your cognitive resources in the pursuit of alpha. Noise scrambles your awareness and your ability to manage your emotions.
Without noise, discipline would be a doddle. But because you do experience noise, discipline is difficult, especially when it matters most. Active management of noise is the foundation of better investment discipline. And when your investment discipline is better than your competitors, you have an edge.
- What emotions are most likely to lead you astray?
- What kinds of noise give rise to those emotions?
- How will you actively manage that noise?
- Justin Newdigate: Noise (2019)
- Robert Hagstrom: The Warren Buffett Way (1995)
- Warren Buffett: Chairman’s letter to Berkshire shareholders (1990 & 1986)