Before investing, one needs to first understand own emotions and learn how to control them.
By Amr Hussein Elalfy, MBA, CFA
5/10/19 5:38 AM
In the United States, the word “school” is used interchangeably with any place where students learn, be it a high school, a college, or a university. Back in my school (Baruch College), my first-ever class was BUS 1000 (Business Organization and Management, now known as Introduction to Business). BUS is short for Business, and for some reason, the school had a system of numbering courses with four digits, unlike other colleges that used three digits. Anyway, that course was a must-take for all students who were enrolled in school, regardless of their intended major. It was like an eye-opener and set the scene as to what to expect in the future as I was stepping into the business world. If my memory serves me correctly, the school’s curriculum had set some prerequisite courses that all business students had to take before progressing in their studies. One of those courses was PSY 1001 (General Psychology). At the time, I was wondering how psychology would help me in business, especially that I was going to major in Finance & Investment!
Years later, I still remember some of the key topics that I studied in that psychology course. In fact, I may have forgotten what I studied in some of the finance courses I had taken, but I still remember my psychology course! Having succeeded in the CFA Program (CFA stands for Chartered Financial Analyst), it turns out that there is an important link between finance and investment on one hand and psychology on the other hand. Indeed, there are currently two fields that are taking the front seat in the business world, namely behavioral finance and behavioral economics.
What the two fields address is how psychology impacts our decisions, whether investment or economic. As discussed in my previous articles (Back to Investing Basics and Investing 101: We the Investors), the magic formula for successful investing involves more than simply selecting the right asset, sector, or security to invest in. It involves the timing of that selection and—above all—what price level to take a position at. In “Security Analysis”, one of the timeless books about investing, the principle of "Margin of Safety" was introduced by the book authors, the well-renowned Benjamin Graham and David Dodd. Simply, the principle of “Margin of Safety” attempts to fix a recurring weakness in the world of investing, which is investing at the wrong price. It is when an investor purchases a security at a market price that is significantly below its intrinsic value. Some pundits set that margin at 30-50% discount to intrinsic value. In other words, if a security (say a stock) is believed to be worth USD100, then the principle of “Margin of Safety” would only permit purchase if the security’s market price is at maximum of either USD70 (in the case of a 30% discount) or USD50 (in the case of a 50% discount). By purchasing a security at a discount to its intrinsic value, investors would limit their losses substantially—one key aspect to successful investing.
So, where does psychology fit in the whole picture, you may ask. For one, the discipline to stick to this principle of “Margin of Safety” is in and of itself a psychological decision that investors need to knowingly make. Psychology does have different twists that spill over the whole investment process, which we will cover in our next article. Until then, be disciplined and stick to your “Margin of Safety” rule. For me, I will always remember my Psychology class whenever making an investment decision.