Protection Against a Dangerous Enemy

By Vitaliy Katsenelson, CFA

February 15, 2005 – Motley Fool

A few nights ago I was awakened by my two and a half year old son Jonah at two o'clock in the morning. He was whimpering and crying out for us to pick him up and bring him into our bed. We succumbed.

For the next couple of hours my dear wife and I would receive the occasional kick in the stomach, or elbow to our eyes, ears, and other vital body parts. Oddly enough, this experience made me realize that investing is often not very different from parenting.

Let me explain. As tired, sleep-deprived parents, my wife and I made an emotional decision about a year and a half ago. We gave into Jonah's cries and acted on our emotions by bringing him into our bed in the middle of the night. The harder, more logical route would have been to calm him down and let him fall asleep on his own, in his own bed. If we had done that, we would have been enjoying eight hours of uninterrupted sleep for the last 18 months, and Jonah would've gained the security to sleep on his own.

Clearly, emotions are a large part of both parenting and investing. Unfortunately, emotions often cloud our judgment and steer us toward making erroneous and irrational decisions. Emotions are a far more dangerous enemy to investors than anything Elliot Spitzer has unearthed. Emotional decisions are worrisome because they are usually made to satisfy an emotion that is short-term in nature. In the absence of emotions, the decision often would have taken into account the long-term consequences and therefore, would have been different.

For example, emotions were responsible for investors suddenly waking up after the tech meltdown, and finding that "boring" blue-chip stocks like Wal-Mart(NYSE: WMT) and Coca-Cola(NYSE: KO) had been replaced by exciting, but now considerably less valuable stocks like Sun Microsystems(Nasdaq: SUNW) and JDS Uniphase(Nasdaq: JDSU). As recent history instructs, emotions lead us to buy stocks like there is no tomorrow during a bull market and dump them during a market decline; these are not the actions of a rational investor.

A very effective way to maintain rationality and fight off the desire to act on emotions is to create rules of engagement for your portfolio: an investment policy. An investment policy doesn't need to be very formal, but it helps to have it written down, since it is easy to forget your plans from even a week ago, let alone a year or two ago. An investment policy should be created at a time of emotional tranquility. It should spell out your investment goals and specifically define the strategy for achieving them. Asking the following questions can help you create a simple investment policy:

• What is the purpose of investing (retirement, college, larger boat)?
• How much money is needed to achieve these desired goals?
• What rate return will be required to achieve these desired goals?
• What is a tolerable level of risk?
• What asset allocation will produce a required rate of return and still fall into the comfort zone of risk tolerance?
• How often will the portfolio be reviewed and rebalanced? (It should not be more than twice a year.)

Once an investment policy is created, it should be looked at as an investment constitution. Not unlike the Constitution of the United States, amendments should not be made on a whim and should require considerable deliberation and the input of trusted and involved advisors, friends, or relatives.

An investment policy is the unemotional "you," made at a time when you were thinking clearly and rationally. An investment policy will provide you peace of mind. No matter how volatile markets become, you will have a lucid strategy for rational decision-making.

Being emotional is part of being human. Finding a way to make rational decisions under emotional pressure is what makes us good parents and successful investors.

Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He owns no shares of any stocks mentioned above. The Motley Fool has a disclosure policy.Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.