Don't let emotions spoil your investing

Part 3 of this year's list of recommended books focuses on how to think critically.

By RPrichard Nov 15, 2010 11:34AM

Money books © gulfimages / Getty ImagesBy Vitaliy N. Katsenelson

I originally wrote a list in 2008 and again last year. I intend to keep adding to and revising it every year. It contains seven sections: Selling, Think Like an Investor, Behavioral Investing, Economics, Stock Market History, Risk and Books for the Soul. Today's segment is Part 3. Read Part 2 here, and expect Part 4 tomorrow. I hope you enjoy it.

 

The right temperament is crucial in investing. Being a critical thinker and knowing how to value stocks are important, but it is all a waste if your emotions get the better of you. The following books will help you to recognize the shortcomings of your hard wiring and help you to devise strategies to deal with it.

 

"Psychology of Investing," by John R. Nofsinger, is short and to the point. You'll become an expert on behavioral investing in about an hour. Well, not quite, but close.


"Why Smart People Make Big Money Mistakes And How To Correct Them," by Gary Belsky and Thomas Gilovich, is a fun and easy read. It also addresses how shortcomings in our wiring affect money decisions, like buying cars and stereos.

 

"The Little Book of Behavioral Investing," by James Montier, is another good read.  James used to be a global equity strategist at SocGen, a large European financial institution.  I read his research religiously, the only sell-side research (with the exception of Albert Edwards, who was James’ partner, and Dylan Grice, who took James’ place) that’s worth reading.  This book is written for value investors by a value investor who happens to be the leading thinker in behavioral finance.  This is the only behavioral investing book that I am aware of that that quotes Ben Graham, Seth Klarman, John Templeton and Warren Buffett throughout the book and synthesizes their lessons with those of behavioral investing.

 

While the three books above cover many topics in "Your Money and Your Brain," by Jason Zweig, Chapter 10 is what makes this book a must-read. It addresses happiness -- yes, happiness. Although, as most of us know, money doesn’t buy happiness(unless you are starving or living in a cardboard box), money spent on buying things brings a burst of happiness that quickly fades away. Think of how happy you were on the day you bought your first car. Now fast-forward a few weeks later.  The rush almost certainly faded. Money spent on experiences, on the other hand, brings a higher utility of happiness. Recollecting experience brings happiness. ( take a lot of pictures and videos to remember things better.)  Zweig also provides a list of things you can do that will make you happy, and none of them require you to spend a penny, which is a big positive in today’s economy.

 

Though traders and value investors fish in the same pond – the stock market – and may even catch the same fish at times, their approaches and analytical timeframes are diametrically different. Value investing and trading, however, share a common element: Both are done by humans, and thus are affected by emotions. That’s why I also recommend a fictionalized novel that provides a great introspective look inside a trader’s mind and teaches many behavioral and common-sense lessons. "Reminiscences of a Stock Operator," written in 1923 by Edwin Lefevre, depicts from a first-person perspective the early years of the great trader Jesse Livermore. It is rumored that this book was actually written by Jesse Livermore and edited by Lefevre. Here is a sampling of the book’s insights:

 

"Another lesson I learned early is that there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market to-day has happened before and will happen again.

"A man must believe in himself and his judgment if he expects to make a living at this game. That is why I don’t believe in tips. If I buy stocks on Smith’s tip I must sell those same stocks on Smith’s tip.

"The recognition of our own mistakes should not benefit us any more than the study of our successes. But there is a natural tendency in all men to avoid punishment. When you associate certain mistakes with a licking, you do not hanker for a second dose, and, of course, all stock-market mistakes wound you in two tender spots—your pocketbook and your vanity.

"One of the most helpful things that anybody can learn is to give up trying to catch the last eighth or the first. These two are the most expensive eighths in the world. They have cost stock traders, in the aggregate, enough millions of dollars to build a concrete highway across the continent."

 

I’ve read this book a few times, but couple of months ago I was fortunate to read a brand-new edition annotated by Jon Markman. Jon's skillful notes take you behind the scenes of the Lefevre's story and provide important insights into characters and the backdrop of that very interesting period. Jon's annotations are almost like a book within a book.

 

Another good book about Livermore is called Jesse Livermore, by Richard Smitten. Here's one of its best passages:

 

"After several months of despair, Livermore finally summoned up the courage to analyze his behavior and to isolate what he’d done wrong. He finally had to confront the human side of his personality, his emotions and his feelings. . . . Why had he thrown all his market principles, his trading theories, his hard-earned laws to the wind? His wild behavior had crashed him financially and spiritually. Why had he done it? He finally realized it was his vanity, his ego. . . . The outstanding success of making more than $1 million in one day had shaken him to his foundations. It was not that he could not deal with failure—he had been dealing with failure all his life—what he could not deal with was success.

 

"The Big Short" by Michael Lewis.  Michael Lewis is one of the best story-tellers Wall Street ever produced.  So you would expect from the author of “Liar’s Poker” a fun, well written book that tells you how Wall Street machine does what it does best: taking an average-size bubble and making it enormous. No surprise there. But this is not just another “how Wall Street screwed everyone” book.

 

Lewis tells a story of a few brave investors who shorted subprime mortgages at the height of the real estate bubble.  From today’s perch, it seems like a no-brainer trade after all, we are blessed with the wonderful benefit of hindsight.  But Lewis sets aside this hindsight, delves into guts of Wall Street in the midst of the housing bubble, and shows the emotional rollercoaster his heroes went through before they were proven right. 

 

This book teaches a valuable lesson about the difficulty, frustrations and rewards of being a contrarian, a tiny minority daring to contradict 99% of investors. This book reinforces that when you make a contrarian bet, you better do your own research, otherwise the pressure of the crowd will overwhelm you. Be prepared to be “wrong” for longer than you rationally expect; make sure your investors will stick around long enough to allow you be proven right; and finally, have a support system – a few friends and colleagues who will provide vital emotional support.  



Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of Active Value Investing (Wiley, 2007) and the upcoming The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or you can read them on ContrarianEdge.com.

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