Investors often become blind to risk, especially when emotions get involved. In this column, I will describe two instances of this, using Apple�s recent decline as an example, and I will offer insight explaining what could be the next real instance of the peril of emotional investing.
In 2007 everything looked great. The market was about five years into its recovery after the two-year drubbing that followed the Internet bubble, and the economy seemed to be on the right track. Emotions began to run high, but to be more specific, people started to become greedy too.
Another way of thinking about this is that people began to expect very good things from financial assets of almost all types. They saw good returns in the past, and they expected good returns as a result, but what they failed to remember was that the market had barely gotten back to where it was in 2000.
Resulting declines that began late in 2007 ripped the rug from under investors who decided to get in again in the middle of 2007. Many of those investors also refused to sell when the tides began to turn because they believed all would be okay. Emotional investment decisions by these Johnny-come-lately investors spurred them to buy late in the cycle, and because those assets were underwater, emotions also played a role at keeping them from selling and taking a small losses, too.
More tangible to recent action is the emotions that built up in Apple (AAPL) during most of 2012, only to abate as the year came to an end.
Also related to emotions, but a derivation that deserves its own category, investors who refused to secure gains in AAPL, who were probably the same investors who refused to see the changes that were happening and were subject to �Golden Handcuffs.� Golden Handcuffs is a form of emotional investing that prevents an investor from securing gains when the signals arise because he has become so closely tied to a company.
Our investor has done the research, knows the management, knows the products and knows the history, and that research prevents him from selling even when sell signals come. In the case of AAPL, serious problems were becoming obvious after the first quarter of 2012, but those took a few quarters in order to surface in the media, but here they are.
The emotional roller coaster that brought Johnny-come-lately investors into AAPL in 2012 is not unlike what tempted investors back into the market when it was near its high in 2007, but the Golden Handcuffs associated with AAPL may unfortunately keep them from making good decisions even when the next sell signals come. Our analysis suggests that a buy signal may come for AAPL far sooner than the next sell signal, but such a signal has not yet surfaced, and we are being patient with AAPL for the time being.
These two examples help us all see the perils of past emotional investment decisions, but looking to the past only helps if we can apply it to the future. What we know about today�s market is that we are going on six years from where the 2007 peak was, which is about the same as the difference between the 2000 peak and the 2007 peak interestingly.
Investors are happy, and they believe the market will continue to go up, almost endlessly. I do not want anyone to be anything but happy, but I also recognize that these good times have turned bad in the past. This transition happens near market peaks always, and for those investors who make good decisions when emotions are running low will not be forced to make emotional decisions when the going gets tough.
Ultimately, it is that second part that really makes the difference. An emotional decision to sell that comes after an emotional decision to buy is usually a losing trade, and when that is accompanied by Golden Handcuffs, it could be even worse.
As investors we need to rid ourselves of these emotional ties, we need to take off those Golden Handcuffs, and we need to be prudent and proactive with our decisions. Even the Oracle of Omaha is proactive, he sells and buys all the time; Warren Buffet will raise cash when he thinks the market or a stock he holds is ahead of itself or in trouble, he will jump in near market bottoms, but he is only able to jump in more aggressively near market bottoms because he has the liquidity, much of which usually comes from selling some portion of his holdings near market tops.
To rid ourselves of emotion is not easy, and probably not even possible for most people, but the closer we can come to making prudent investment decisions, the more able we will be to avoid cases like the drubbing that followed 2000, 2007, and more recently AAPL, and in turn the more apt we will be to pick up the pieces and buy near market lows when the trough of the cycle again comes.
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