"Impulse is the medium for emotion; the seed of all impulse is a feeling bursting to express itself in action. Those who are at the mercy of impulse -- who lack self-control -- suffer a moral deficiency. The ability to control impulse is the base of will and character."
Ok, so maybe the "moral deficiency" doesn't apply to investing, but this quote from Daniel Goleman's Emotional Intelligence sums up the ideal investor mentality. Controlling our emotions when making investment decisions is something we all struggle with. Therefore, I nominate Emotional Intelligence as one of the great investing books and am adding it to the reading list for individual investors.
The book has nothing to do with buying stocks or valuing companies and everything to do with grappling with emotions. Goleman postulates that the more control you have over your emotions, the more emotionally intelligent you are. He labels emotional intelligence as EQ to separate it from the antiquated measure of book smarts better known as IQ. I'm postulating that the more emotionally intelligent you are, the better an investor you are. Ivy league MBA grads may have IQs and GMATs that impress, but it's the EQ that separates investors, not the IQ.
The book gets into what Goleman calls the most baffling moments in our lives -- when feelings overwhelm all rationality. He offers physiological and psychological explanations for why we feel a certain way or why we act irrationally. And when all is said and done, the best way to act rationally is to understand why you want to act irrationally. Understanding your own emotions is the key to emotional intelligence, and there's no species around that needs more emotional intelligence than the investor. Separating money and emotions is what it takes to buy and hold.
Investors are constantly grappling with psychological highs and lows. In order to maintain our sanity, we need to contain those feelings in some sort of rationality trap. If we let them run wild, well then, the theories about monkeys and dartboards offered up by Burton G. Malkiel, author of A Random Walk Down Wall Street, don't sound so ludicrous. A number of books have attempted to explain market psychology by studying group dynamics and mob mentality, but where does that leave us? It simply states the obvious: Mob rules rule the Street. We know that.
Sure it's helpful to understand how a crowd will react to this or that, but what investors really need is a fundamental understanding of how they will react to this and that. Knowing is half the battle. If you know why you are reacting in an illogical manner, you have a much better chance of steering into the wind before your boat keels too far.
That's why setting goals for your individual investments is crucial to managing your emotions. Rather than let the market's moods dictate when you sell, let logic dictate these decisions. Investors should set financial markers that require a reevaluation of each investment. Don't stop there. Set portfolio goals as well. With goals in place, your buy, sell, and hold decisions are less emotional.
So what's your EQ?
Emotional Intelligence offers readers several platforms for evaluating their EQ. Concepts like self-awareness, delayed gratification, and impulse control are discussed at length in the book. The first step toward emotional intelligence is gauging your predisposition. Are you an optimist or pessimist? A hypothetical situation offers a good test. Think back to you school days and answer the following, paraphrased from Goleman:
You're shooting for a B in biology, but when you receive the result of your first exam, which is worth 30% of your total grade, the grade is a D. What do you do? Are you motivated to work harder? Do you feel the D is too much to overcome and immediately lower your goal to a C? Do you withdraw from the class?
Your response gives you a decent measure of your optimism and pessimism. It also sheds some light on your motivations. Answer honestly and label yourself. If you tend to be optimistic, then you should monitor your excitement about your favorite stocks. If you're a pessimist, maybe you're not giving the business model or financial projections enough credibility. And if you immediately lower your expectations from the example above, watch out, you may suffer from extrapolitis.
This brings up the issue we discussed last week with Intel (Nasdaq: INTC). It's easy to look at the earnings and revenue trend lines of Intel and say, "By 2006, Intel will be making $1 on $10 of revenue." We know that's not the case, but our emotions are pulled in different directions. The optimist thinks Intel will have no problem rebounding and may even believe greener pastures are ahead. The pessimist gives Intel one chance in twenty of coming out on top.
Whatever your outlook, make sure you know what deck of cards you're playing with. Know what your tendencies are and temper them with wisdom. Emotional intelligence is not about bottling your emotions; it's about dealing with them in a logical manner. What else could explain why Berkshire Hathaway (NYSE: BRK.A) chairman Warren Buffett has been able to hold on to Coke (NYSE: KO) for the past four years?!
Regarding last week's promise to touch on Intel's valuation, I simply wish to re-emphasize that Intel's business is cyclical and therefore using average margins and average growth rates over an entire cycle to discount its future cash flow is a must. With limited visibility in the semiconductor market and pessimistic near-term outlooks, the shares look pricey. That said, per-share 2001 earnings estimates have dropped from $1.65 a year ago to $0.45 today. As the fog clears and chins perk up, I expect earnings estimates to do the same, which will bring Intel's P/E down to a more appropriate level.
Todd Lebor doesn't believe in luck, just good old-fashioned hard work and bribery. At the time of publication, he owned shares of Intel. Todd's other holdings can be found online along with the Fool's complete disclosure policy.