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Mastering the 7 Emotional States of Advisors and Investors

We all know that our emotional state impacts our decision making ability in our world as advisors. When the markets are going up, we get greedy. When the markets are going down, we get fearful. And weʼve seen the empirical evidence regarding the disconnect between investment returns which are mostly market driven and investor returns which are behaviorally driven (i.e: buying high and selling low) But there are other more subtle emotions at play throughout market cycles that can influence us more than we think. The question is : how can we master these emotional states to make better decisions and lead clients to better returns and a less stressful life?

The answer is to become aware of the 7 emotional states associated with the market cycles. And by having a better understanding of the link between market cycles and how we feel, we can make better, more objective decisions. Forewarned is forearmed. Then you can develop counter strategies to prevent making mistakes in the heat of those moments. You can be empowered to take advantage of opportunities during those times rather than be a victim of those times. After you go through these, see if you can guess where we are right now in the cycle.

1. Confidence
This is the stage where the fundamentals of the economy appear to be sound enough for there to be optimism in the future. The news flow has its usual focus on some negatives, but there are enough positives in the data and boardrooms that we see hiring. We see new initiatives, new ventures being launched. There is usually a hot new thing that gets everyoneʼs attention. There is faith in the future, a willingness to take some risk. There is actually a nice balance during this phase between the demands and expectations of investors and the reasonable recommendations of financial advisors. Everything is sunshine on the meadow at this stage – everyone is expecting good things. If as an advisor you were to measure your influence over clients on a scale of 1 to 10 with 1 being the lowest and 10 the highest, you are probably a solid 7 at this point.

2. Greed
Now lets fast forward in time – maybe 12 to 24 months out. The bull market is not only in full swing, its enthusiasm has become contagious. The mood of investors is almost giddy. The news flow is so good that investors who missed the boat are feeling really, really stupid. I would argue that it is more psychologically painful to watch a missed opportunity succeed than to watch what you thought was a winner drop. They say that fear of loss is stronger than the desire for gain. But that is incomplete. What makes greed so insidious, if not bridled, is the fact that you desperately donʼt want the ride to end. And if you are one of the few still sitting at the train station, you are feeling not only like you are missing all the fun but something far deeper than that: you are feeling isolated and alone. There is a social dimension to investing that is way under-appreciated. For example, how many of us have an uncanny ability to make major purchases at what prove to be market tops? But this is understandable. Because we are in this industry, we tend to make more money when the markets are going up. Therefore we have more discretionary dollars. And the other thing that happens is we begin to extrapolate recent performance way out into the future (can anybody say mutual fund “mountain chart”). We tend to think that the most logical conclusion is that there is somehow a predictive quality to recent trends. We believe that “the trend is your friend”. And surprise, surprise – we have the most friends when things are up. But now we begin fantasy thinking. During the dot com bubble, did you have any clients that left you because you only made them 30 % and their buddy at the country club made 60% the same year?

3. Denial
In this phase the bubble has burst but very few actually heard it pop the moment it happened. Only through the rearview mirror can we accurately assess the exact timing of when things took a turn for the worst. This is almost always some watershed event or catalyst that becomes identified with the change from one stage to the next. I remember once returning home from a conference speaking engagement at midnight on a Friday night eager to see my family, only to discover my car had a flat tire. Fortunately Iʼm a AAA cardholder and with a simple phone call was able to get on the road again within an hour or so. But when I took the old tire into the shop the next day, the mechanic walked out of the garage carrying a three-inch nail and said, ” This is why you got the flat. You probably hit this several days ago and didnʼt even know it when it happened. Then the leak finally took out enough air for you to notice”. When I think back, there may were some clues like a slight pull to one side. There may have even been a warning light but I was too busy to notice. Its the same at this stage. Because the good times have been going for a while, out first reaction is denial. We see what we chose to see. There is a built in bias that goes something like this: Whatever action we have taken becomes the right one merely as a result of us making that choice.

4. Fear
This is the most powerful four-letter word in the human experience. We know that the fastest way to change a personʼs behavior in the short term is through fear. When it comes to investing, this is the stage where the most mistakes are made by far. There can be a “fight or flight” response hard-wired into our brains from our ancient ancestors that leads to impetuous decision making. This stage is marked by alarming one-day price swings in the markets. And its so important I think it actually has three sub- stages:

  • Shock; As investors move from denial to fear, the initial wave of emotion can best be
    described as “shock”. Its like a death in the family. What is our first reaction? We may
    have been in denial about all the things leading up to this moment, but nothing
    prepares us quite like facing the music. Nothing stings quite like emerging from our
    cave to see whatʼs really happening in our environment. Its the reality sinking in for
    the first time as you finally open your monthly statements and see just how far things
    have gone down. If youʼve been ignoring the news, you start to tune in. The news
    has taken a decided turn for the worst.
  • Panic: Do you have clients that are excellent anecdotal barometers for what is going
    on in the minds of other investors? Are they often excellent contrary indicators?
    When they finally call excited to buy, you want to consider selling. When they finally
    canʼt stand the pain any more and came in to “sell everything” and panic sell, that
    usually marks at least a short term bottom in the market. This phase is often
  • Blame: After panic, there is tremendous internal pressure to rationalize that action or
    that decision. We will go out of our way to prove that what we did was justified under
    the circumstances – even smart, wise, prudent etc. But invariably there needs to be a
    scapegoat for our tale. We need to have a bad guy in our story to make us look like
    more of the hero. And guess who often gets the blame? You guessed it – the advisor.
    This is about pointing fingers and feeling better because if its somebody elseʼs fault
    then by definition its not our fault right?

5. Guilt
As time goes by, after fear has been the predominant emotional driver in our decision-making process, we begin to reflect back on what has happened with some perspective. We start feeling guilty about what transpired, even ashamed in some cases. Its much like being in the heat of an argument and realizing later that maybe the other side had some good points. As the markets start to bottom out, we examine what we did or didnʼt do and the second- guessing begins. Maybe we panicked. Maybe we made a hasty decision. We may feel overwhelmed with grief. “My portfolio died at my own hand”. For example, have you ever had a client sign up for dollar cost averaging into a fund only to bail out when the markets dropped? One situation that stands out in my memory was just prior to the gulf war in 1990. My client was getting more shares as the price dropped but psychologically he couldn’t stand the pain and stopped making contributions right before the shots were fired – and of course we know what happened after that – the market took off. And over the next year, he transferred his account. And it had nothing to do with the quality of advice he got. Had he stuck with the strategy, he would have been in great shape. Aside from the loss of pride, the dominant emotion at play was likely his own guilt for not sticking to the original plan. Have you ever had clients like this where the relationship is just never quite the same? No matter what happens next, the relationship has been contaminated and the only way to cleanse it is to move to another advisor. Would you say there are many clients out there right now feeling this way? Thatʼs why this is such a great time to prospect.

6. Apathy
After dealing with guilt, we see that this whole experience has left not only scars but also exhaustion. One sure sign that we are ready for the next bully market is that people begin to totally lose interest in whatʼs happening in the market. Do you remember thinking that the housing market had to be topping when the reality show “Flip This House” began to air? News fatigue sets in at this stage and we find ourselves becoming interested in other activities. We often look inward and get more grounded. Weʼre now beyond negative media telling us how bad it is – its obvious that there is no value in continuing to beat a dead horse. At this stage, the few sellers left have run out of stock to sell and the few buyers have agreed to pay that clearance price.

7. Doubt
Stocks are supposed to be discounting mechanisms which is why novice investors are so shocked when stocks begin to move well in advance of the actual good news unfolding. Its this kind of doubt – that wall of worry that can cost investors dearly at the beginning of a new bull market. But without doubt, there can be no
opportunity. If by process of elimination we determine that we are in this stage – a real buying opportunity is presenting itself because the fact is that as Sir. John Templeton said years ago: “bear markets are always followed by bull markets”. Are you doubting that we are in a recovery or a bull market? That in and of itself might just be the sign you have been looking for to put money to work in stocks.

So after reviewing these 7 emotional states, how are you feeling? Where do you think we are in the cycle? If you can narrow it down ,you can better anticipate what is likely coming next and better prepare. Warren Buffet says that the key to investment success is to be “greedy when others are fearful and fearful when others are greedy.” But by becoming much more aware of the impact of these other emotions on investor behavior, we can better fine tune our approach with clients to save them from themselves – and sometimes from ourselves.

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