Last week, we talked about the emotional undercurrents that make investing hard. This week, we’re talking about some of the systems we can use to protect ourselves from those emotional undercurrents.

What Not to Do as a Portfolio Manager

I lost $750,000 on my first macro trade as a portfolio manager. My boss (the Chief Investment Officer) wasn’t upset with me for losing the money, but rather how I lost the money.

Our team had a systematic process for how we structured and put on trades. When one of the portfolio managers had a trade idea, we’d write it up into a document called an investment memo—specifying the basic theme of the trade, underlying rationale behind the trade, the instruments to be used, the date we wanted to put it on, how long we wanted to stay in the trade, and so on. But the most important part of the memo was the exit thresholds—if the trade went against us, how much money were we willing to lose before we got out.

So I wrote up the memo, pitched it to the other portfolio managers and the CIO, and got the green light to put the trade on. So we went in.

In one day, we were down $250,000. That was our stop-loss on the trade.

The investment memo said to get out at $250,000 of losses. But I “believed” in the trade, so I convinced my colleagues that we should stay in the trade, who helped me convince the CIO, who agreed and we stayed in.

Two days later, -$750,000, and the CIO comes over and tells me, “you’re getting out of this trade.”

Ego

People think investing is about money. That’s true, but it’s only true when we take all the emotional baggage out of it. When there’s emotional baggage, it’s not about the money, it’s about something else.

For me, that trade was about my reputation and standing with my peers. I was a new portfolio manager, with strong ideas about the market, and more than anything else, I wanted to prove that I was smart. That I had good instincts, the ability to read the market, and be aggressive when the opportunity presented itself. The trade failing, subconsciously to me, meant that these things were not true. My ego got involved.

Best practices like writing investment memos with stop-losses exist because people have egos and get emotional and lose sight of their own discipline. There’s a saying—not sure where it comes from—that we rise to the level of our willpower and we fall to the level of our systems. When we become emotionally dysregulated, as I was when the trade started going against me, we are “falling” and we need our systems to save us. When I’m unable to exercise discipline, the system exercises discipline for me.

Finance Systems That Protect You from Your Own Impulses

I want to go over a few systems in the world of finance and investing that work. I won’t discuss what they are, but rather the emotional storms that they protect us from.

Many of these systems focus on being “good enough” rather than perfect.

Diversification

Protects from: FOMO, panic

Diversification is a salve against being 100% wrong. If a stock does well, I don’t have total FOMO—I have a bit of it, and get to enjoy some of that emotional lift of being in it. If a stock does poorly, I’m less stressed because all of my eggs are not in that basket.

Automatic Saving

Protects from: indecision (fear)

People in general are overwhelmed by the amount of decisions they have to make. Automatic saving—investing the same amount of money automatically, every month—works because it takes the “do I get in now or do I get out” decision out of our hands. It’s “good enough” to get the compounding of long-term average rates of return, even if your return could be better with perfect timing.

Budgeting

Protects from: impulse buying (spending money to satisfy a short-term emotion), fear of the unknown

Budgeting isn’t useful for everyone, but it can be very useful for people who use money to cope with emotional dysregulation. If I feel upset every time I interact with a particular family member, and my typical response is to spend $200 on online shopping immediately afterwards, setting a budget can be a useful brake to stop me from reacting to that emotional pattern the same way every time.

I personally find budgeting useful when I’m considering major financial changes (like quitting my job and buying a house) and those changes feel scary. By mapping out how much money I’m likely to spend, I go from “what if I run out of money” to “I will run out of money in 30 months.” The latter is less frightening than the former.

Stop-losses

Protects from: inertia, ego/pride

Stop-losses are basically about admitting when you’re wrong. In my trade example, a veteran investor like my boss would have immediately admitted his read on the market was wrong and would have cut his losses without any emotional attachment to the trade. Lacking that discipline, I needed a stop-loss.

In highly stressful situations, people also sometimes freeze. This can happen to traders when the market is experiencing rapid, sharp moves. In a situation where emotional stress is high and our logical functions shut down, we can rely on the thinking we did in advance of the stressful thing happening. This is why people do emergency drills, so in an emergency situation, we don’t panic and instead default to the training we had before the emergency happened.

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Next week, we’ll talk about the end state—the kind of investor we eventually become when we master the use of systems in our lives.

Exercise

Journal on the following or discuss with a friend.

1)      Noticing

When do I tend to become emotionally dysregulated in matters relating to money, finance or investing?

Does my pride or ego become involved?

Do I spend money without thinking?

Do I feel fear at looking at my finances?

There are many ways to become dysregulated when dealing with money. Don’t restrict yourself to these.

2)      Desired state

How do I want to feel when I deal with money, finance or investing?

Do I want to feel emotionally unattached to the outcomes of investment decisions?

Do I want to feel that my spending is deliberate?

Do I want to feel that money management is something automatic, that triggers little or no emotion for me at all?

3)      System implementation

What is a system I can implement that can help me move from my current emotional state to my desired emotional state?

There are many more systems than the ones I’ve described here. Identifying the desired shift in emotional state, and then experimenting with different systems to see if they work for you is the right approach.

Also, some things may not work on the first try! Using systems also involves learning how to use them, and learning is a product of skill and experience, and skill and experience are products of trying and failing and making mistakes.