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spacer July 2003

Where most investing issues are concerned, there is a herd that stakes out the majority opinion, while plenty of lone bucks collect at the fringes with their own points of view.

On a few concepts, however, there is near-universal agreement, where seemingly everyone -- buy-and-holders, chartists, day traders, value mavens, growth aficionados, momentum players -- can see eye to eye. One such idea is that it is necessary to eschew emotion in order to ensure a disciplined approach and become a successful investor.

It is curious that an unqualified consensus regarding "emotional antipathy" is to be found only in the field of finance.

In other arenas, our culture champions emotion as more authentic: professional athletes, for instance, are expected to play with zeal and emotion, fuelled by adrenaline and pushing themselves to the limit, yet without taking stupid penalties or injuring other players. When they fail, their "desire to win" is as likely to be questioned as their talent. In the movies, heroes routinely confront scenarios where logic would suggest a hasty retreat, but guts and bravado in the face of long odds are what lead them inexorably to triumph.

On the political stage, a leader who cannot summon up emotion in speeches made on the stump is considered to be unelectable. A lack of emotion is equated not only with a deficiency of passion and heart, but with limited horizons -- what George Bush the Elder once dismissed as "the vision thing."

Crimes of ferocious violence shock us, but nothing is more frightening than the cold-blooded killer. As Dr. Chilton says of Hannibal Lecter, "His pulse never got above 85, even when he ate her tongue." Yuck!

It is in science fiction where the emotion/logic dichotomy is often most overtly explored, as feeling and intuition are often pitted against the cold, pitiless logic of the machine. Commander Data may continually strive for his humanity, but Wall Street would suggest that his utter consistency, and inability to be distracted by the frailty of emotion from his reasoned course of action, would make him the perfect day trader.

So, is Mr. Spock fated to retire in luxury while Dr. McCoy blows his savings in one hair-brained scheme after another?

We'll answer that question with a question: If emotion is so counterproductive to good investing, why are so few investors successful?

As a group, mutual fund managers tend to be well educated, and great efforts are made to ensure that they follow rigorous methodologies that reinforce discipline and conform to the investing style set out in the fund prospectus. Then what about those whose funds are outperformed by the market? They can't be acting solely on poor instincts and dumb hunches.

We are led to one of two conclusions: either emotion is really as detrimental as everyone says it is -- but the majority of dispassionate investors simply fail somehow to meet the bar they set for themselves -- or perhaps, in the headlong pursuit of discipline, they are missing out on something.

Emotion's bad rap seems to come from the assumption that it is inherently illogical.

That's just silly. Emotion is an "emergent phenomenon," one which may be more complex than even the alfalfa people give it credit for.

"Falling in love" is not necessarily logical or illogical, but a behaviour based on myriad subtle perceptions, a combination of tiny events and decisions. Trying to determine whether one's choice is "good" or "bad" also puts us on extremely shaky ground, as that evaluation is based on perspective and standards of what makes a good match.

The issue, then, is not so much whether discipline must trump emotion, but whether you have a realistic model of the world salted away in your cranium. Logic and intuition are both useful ingredients in the making of sound judgements. Emotion is a problem if it is too distracting or haphazard, but it can be a powerful conduit to our ability to apprehend patterns.

Let's say I'm playing a game of chess and my opponent makes a move that I immediately perceive as weak. I feel pleasure -- an emotional response -- because I want to win and my intuition indicates that the road to success has been opened.

In a slower-paced tournament game, I will analyze whether the weakness is real or imagined and how it can be exploited. If I am playing a game of "blitz," a snap judgement will suffice.

In this case, intuition is clearly not some kind of innate knowledge; instead, it is the result of experience, the subconscious recall of the patterns of many past games. The emotion, then, is a "shortcut" -- a way of accessing this body of knowledge without taking the time to run through the possible moves one by one in a logical pattern.

If I am a lousy player, the emotional reaction may be incorrect, and lead me into a trap. But if my accumulated experience represents a good model of what works in chess, I can use my emotional response to quickly and confidently make a sound move.

When the Contra Guys are presented with a ten-year stock chart with a particular shape, we might exhibit an emotional response, as surely as Pavlov's dog would drool.

That doesn't mean our next move is automatically a knee-jerk decision to buy the stock; however, it cannot be denied that this emotional reaction motivates us to investigate further in hopes of confirming the tantalizing possibility suggested by the stock's trading history.

The burgeoning field of behavioural economics studies the psychological dimension of how people make decisions. Roughly 20 years ago, Werner Guth of Humboldt University in Berlin devised an experiment called the Ultimatum Game. In this simple two-player game, one is designated to be the "giver," while the other is the "receiver."

The giver gets $10, and must then propose how much of it to give to the receiver. Once the proposal is made, the receiver has two choices: (1) accept, in which case each player gets the amount proposed by the giver; or (2) refuse, in which case each player gets nothing. There is no room for negotiation, and the game is played only once by the same two partners.

If both players behave according to the classic economic theory of self-interest, the giver should always offer a penny and the receiver should accept it. Why? The receiver is better off taking the penny and running than by getting nothing. Turning down the offer out of spite is futile, as the game will not be repeated and there is no hope of generating a better offer in the future. Knowing this, the giver can safely keep virtually all of the money.

It will probably be no surprise that people behave very differently in actual experiments. Offers of a penny are frequently rebuffed. Many givers will offer close to $5. Such behaviour is driven by emotion -- "That cheapskate bastard is ripping me off, I'll show him!" or "I'll offer $4 because it's close to half, but still pretty fair and leaves a bit extra for me."

To economists, this is completely illogical and an indication of most people's inability to make sensible decisions. But is that really the case? An offer of more than the minimum amount isn't necessarily an altruistic show of generosity -- it can also be a sign that givers appreciate that it isn't in their best interest to make an offer that will insult the receiver. An offer of at least a couple of bucks can arguably be viewed as a canny manoeuvre, a form of insurance, that increases the likelihood of the offer being accepted.

Emotional intelligence is the ability to recognize how we as humans interact with our emotions, the way they play into the decisions we make, and the way we use that awareness to our benefit. In investing, that means understanding that many poor investors can reliably be expected to buy high and sell low and do other silly things that can be taken advantage of. Our mission as contrarians is to feed at this trough.

As the tech bubble inflated, many participants were motivated by the twin emotions of fear and greed -- fear of being left behind, when everyone else seemed to be making easy money, and greed that drove them to keep pressing their expectations ever higher as stock prices passed reasonable targets. But our skepticism in the midst of this hysteria was not the result of dry analysis -- it too was rooted in naked fear, not unlike that felt when you are teetering on the brink on a roller coaster. Stocks simply felt far too expensive, and it scared us. That fear motivated us to make a very conscious, calm decision to cash our profits and decrease the size of our stock portfolio.

Because we place a high value on our own emotional well-being, we manage the Contra portfolio in a way that suits our comfort zone and that provides for a good night's sleep.

There may well be a more optimal methodology that makes more money, but if the cost includes compulsive nail-biting and an eventual ulcer, then we don't want to hear about it.

Discipline is important, but the line between a steady, consistent approach and excessive rigidity is finer than most commentators are willing to admit. The ability to challenge your own opinions and beliefs is critical if you expect to be flexible enough to take into account that the world is always changing -- or simply to admit that you might be wrong.

While emotion can endanger, it can also be a useful investment tool. One would be foolhardy to ignore it.

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