One of the least discussed topics on investing is emotions. I have rarely found any discussion on this topic. Behavioral finance does take up this topic and there is a lot of academic analysis on the various pitfalls and mistakes of investors. However there is still a lack of discussion on emotions and how one should handle them while investing.

Are emotions important?

If you are Mr. Spock, then emotions do not matter. For the rest of us, emotions play a very important role in our lives and definitely in investing.

As an investor, one is faced with feelings of joy, confidence, euphoria or despair, frustration, fear and similar other emotions. I can’t speak for others, but I have had all these emotions and more.

Should feelings be ignored?
One school of thought is that one should be a completely rational investor and should take emotions completely out of investing. I find this as the stupidest advice.

Do you think that is possible? Can you invest without ‘feeling anything?

The only time one does not ‘feel’ anything is when one does not care about it. If you are dealing with your hard earned money, how will not feel anything?

Understand and manage feeling
I have found that it is far more important to acknowledge your feelings and then try to think rationally about them. In some instances, you may be able to realize that your feelings are leading you down the wrong path and you will be able to correct yourself. In other instances, your gut or feelings are telling you something and you are better off listening to them

My own experiences
During the start of my investing life, I rarely thought about how I felt and just went with the flow. For example, if I started analyzing a stock and ‘felt’ confident, then my tendency would be to rush through the analysis and just build a position.

Once I had created a position, a confirmation and consistency bias would set in and I would avoid negative information on the stock if it went against my view. If you think you and others are immune to it, think of the time you and your friends have tried to ‘defend’ your stock (as if your stock needs defending!) and have discounted someone who is giving you contrary information. This tendency sometimes gets vicious on public stock forums (which is one reason I avoid criticizing other’s stock picks)

The converse of the above situation occurred when the stock market was down and everyone was bearish. I found myself overly pessimistic like others and would constantly keep questioning myself. As a result I did not build as big a position as I should have – case in point: I bought concor in 2002-2003 at a PE of 5. I should have built a big position, but never did. Same with blue star and several others

My current approach
I did not get hit by lighting or have achieved any enlightenment like Gautama Buddha. I tend to feel the same emotions as earlier. The difference is that I try to acknowledge them when they happen and to understand what they are conveying.

During 2008, I too had feelings of uncertainty and some amount of doubt. However based on past experience and based on the valuations I could see, I decided to ignore them and went ahead with my positions.

Conversely, I have been feeling fairly smug and happy with my positions and optimistic (atleast till last month) in general. This matched with the feeling, others have about the market. I think this itself is a red flag for me. The time when I start feeling confident and on top of the world is the time to start getting worried. In response to this, I have started reducing my fully valued positions and have not really been buying much (though have been tempted several times).

I don’t go against my feelings always. On analyzing my past positions, I have realized that my position size is driven a lot by my feelings. I maintain a few major and some minor positions (see my portfolio here). I have found that the stocks in my minor holding are cheap and at a higher discount to fair value than major positions.

However for some reason which I cannot articulate, my ‘feel’ for the minor positions is not as good as the major ones. For example, I always felt that a grindwell Norton is a better position than a VST. As a result my position size has been larger in the former than the latter. On analyzing my past results I have found the major positions have done far better than the smaller positions (though I did not realize that at the time of making these investments).

I don’t claim to infallible. Far from it ! I have done enough silly things and confident that I will continue to do so (options may be one 🙂 ). However I think listening to your gut is important, even if you do not always follow it.

As an aside – I think if you feel a little bit apprehensive and scared when trying something new, it’s a good thing. It means that you are pushing the boundary of your learning. I feel the same with arbitrage and options and think that it is the right thing to do.

The previous post stirred the pot quite a bit. I received several comments, which I will try to respond via this post. I wrote about my general thought process without getting into the details of the strategy. I will try to explore some thoughts around that in this post.

Strategy not executable in India
Let me clarify something at the outset, namely that the strategy of buying deep out of the money puts to hedge against extreme events (or black swans), works well with long term options. As far as I know, we only have 1-3 month options in India. I think these options are quite fairly priced and any chances of making money on these options due to mispricing are lower than winning a lottery.

I bought some options once (miniscule amount) to just experiment a bit and I think it is very unlikely I will ever buy short term options to hedge or insure my portfolio.

The strategy in my previous post would work well with long term options with durations greater than 9 months. These kind of options are available in the US market and called as LEAPS. I don’t think such options are available in india yet, so I think my strategy would continue to remain on paper till we have such options.

Justifying an approach
I received several comments and more emails which implied that I wanted to dabble in options and I was justifying it by wrapping it up with the logic of value investing. That may very well be the case, though I consciously don’t think so.

Let me give you an analogy. When we buy a car or a house, don’t we buy earthquake or accident insurance? We don’t hope for an earthquake so that we can collect money on the insurance. The purpose of buying insurance is to protect our asset against extreme events. In order to have this peace of mind we end up paying 0.2% or higher of the asset value as insurance.

Long dated, deep out of the money put options can sometimes serve the same purpose. The trick would be to buy when the premiums are low and the market does not expect the crisis. Ofcourse this is hardly do able in India.

Investing for the thrill
I don’t think I am in for the thrill. I have invested in options a few times and you cannot believe the agony I have gone through during the holding period. Options lose value with time, which is called as time decay or Theta. So if you have a 3 month option, you will lose 20-25% of the value in the first month (with everything else remaining the same). As a result, it has pained me to see my options position lose value everyday.

So with options one has to get the timing right too. I am almost 100% sure that I can never get the timing right. So it is unlikely I will buy options repeatedly to try my luck in the market.

Short term hedge
I would rarely want to hedge my portfolio for the short term via options. My approach is to sell overvalued positions or hold on to it through a market drop if I am convinced about the company. As some of you commented on the previous post, buying short term options would just be a waste of money.

Learning
All of the above discussion does not mean one should not learn about options. I think it is a topic one should explore and learn. There are quite a few interesting possibilities with long term options, especially during extreme market peaks or bottoms. That ofcourse is a separate topic in itself.