Skip to the content

The ‘cycle of emotion’ – when your investment is causing you euphoria it’s time to check out

11 June 2019

Scottish Investment Trust's Alasdair McKinnon explains what the ‘cycle of emotion’ means for investors and how understanding it can give your portfolio greater returns.

By Eve Maddock-Jones ,

Reporter, FE Trustnet

It’s the nature of people to want to be a part of a crowd. For safety and logic it follows that you will do as the people around you are, so long as it’s bringing success. But, this can lead to missing investment opportunities by slavishly following trends.

All of this feeds into the ‘cycle of emotion’ theory, a concept supported by Scottish Investment Trust manager Alasdair McKinnon, who aims to use the cycle to create downside protection by moving against the popular investment themes.

As a contrarian investor McKinnon already aims to invest against the grain, a style he sees as its “in-built strength”.

“This means that we go out on a limb we’re willing to say what we think,” he explained. “We’re not going to pretend that we’re immune to emotion because we aren’t.

“But what we’re saying is that we recognise this emotional cycle and we recognise that when things are going well, there’s not really anyone telling you to watch out. And when things are going badly, there’s nobody telling you that there’s an opportunity.”

Indeed, McKinnon does recognise that this strategy is not completely foolproof and acknowledged that he can leave a stock too early if a trend does continue longer than anticipated.

“You can be too early by being different,” he explained. “You can see why a lot of people just like to run with the crowd.

“The reason we say don’t run with the crowd is, that it’s like the Road Runner and Wile E Coyote.

“You’re running then you run off the edge of a cliff. You’re still running and your legs are still spinning underneath you, [but] then it’s the old comedy fall. And that’s basically what happens.”

Looking into the patterns of the ‘cycle of emotion’ when applied to a stock or a market, McKinnon said that being able to recognise what the stages mean for your position makes investors more open to spotting an opportunity.

 

Source: Scottish Investment Trust

The dynamics of the ‘cycle of emotion’ are that it follows the peaks and troughs of the investment’s returns on the stock market, identified by the human emotions investors will experience at any particular point.


 

The first stage is ‘euphoria’, leading up to the peak return of the investment. Once this high point has begun to slump into a downwards trend you ease off ‘euphoria’ into the ‘content’ stage. But as the slope down continues you become more worried accordingly. Then, according to McKinnon people start to go through ‘anxiety’, ‘fear’ and, finally, ‘denial’.

It’s in the final stage that, McKinnon (pictured) said: “People generally act in the exact opposite to what those opportunities suggest. They’re looking to buy more at the top and sell more at the bottom.”

This ‘fear’ and ‘denial’ stage is where people suffer the most, according to the Scottish Investment Trust manager, and is where these theme-following habits become the most obvious.

“You think that your holdings have been such a wonderful investment making that peak and you’re now afraid to sell it because you don’t know what to do with the money,” he explained.

“You’ve made so much money or your friend made so much money and that’s why you bought it and now the idea of selling just feels absolutely mad because you know this has the ability to make you a lot of money.

“Losing money is bit like a bereavement: there’s definitely a denial stage and there’s definitely a fear stage.”

The reason that people fall into these repeated patterns of following a seemingly successful trend and then holding on for too long are, in McKinnon’s opinion, attributed to human biases.

He said: “When things are going well people will convince themselves that there’s always a good reason to keep buying or you justify it to yourself.

“The big thing about markets is, if something is working people think that it will last forever and just stop asking questions as well.”

This habit of investors following themes and specific stocks that are working at the time leads them to buy into them when it’s already gone past its full profit potential, the manager noted.

“In financial markets if something has gone up, by definition, the opportunity has decreased from it,” he said. “The funny thing is that they think that the proof that it’s worked means that the opportunity is still there.”

What investors should do in this position is revaluate that holding, to see if what they thought was a good opportunity is still adding value to their portfolio, he explained.

This re-evaluation needs to happen in the ‘euphoria’ part of the cycle, said the trust manager.


 

McKinnon said that when the share price starts to increase that is the time to walk away before you spill over the edge into the downside of the cycle.

He said: “First thing to do is to look at the share price. If it’s gone up a lot, worry. That’s your first starting point if you’re viewing it as a cycle.”

The next warning sign that investors need to watch out for is when a theme becomes mainstream.

“What’s on the front page of the newspapers, what are they saying and realising what’s popular,” he said. “I remember in the dotcom boom suddenly all the newspapers started having supplements about technology, then it was housing.

“You think ‘hold on a minute, too many people think that this is an opportunity’. Once the theme has become common knowledge, that’s the sign.”

A more recent example of this is the buzz around FAANG – Facebook, Amazon, Apple, Netflix and Google-parent Alphabet – stocks.

These “unicorn stocks” are the latest in the line of mainstream-profit trends, according to McKinnon, following the dotcom bubble and 2008 housing collapse.

“We are in a stage of almost delusional thinking about the abilities of a loss-making business to dominate the world,” he said. “It can dominate as long as there’s an endless supply of capital.

“It’s almost dotcom-esque in its way of thinking because people just stopped asking questions they just say ‘oh this business is great. It’s got an app, it’s fantastic’, particularly for unquoted technology stocks.”

He added: “People are setting up their own and are incredibly bullish about the prospects for these companies, but really you only need a sensible head to look at what these unicorns do to say, ‘I don’t know how they’re going to make money’.

“People start to say ‘this is it, this is the future’ and that’s when you get bubbles and that’s why you get [valuation] drops because eventually something goes wrong that challenges the whole thinking.”

McKinnon recommends investors be brave and “think outside of the box” because said trends will ultimately keep going until they run out of momentum.

Under McKinnon, the Scottish Investment Trust has made a total return of 58.56 per cent against an 85.24 per cent gain for the average IT Global peer.

Performance of trust vs sector under manager

 

Source: FE Analytics

The trust is currently trading at a discount to net asset value (NAV) of 9.7 per cent, is 12 per cent geared, has a yield of 2.7 per cent and ongoing charges of 0.45 per cent, according to the Association of Investment Companies.

Funds

Sectors

IT Global

Editor's Picks

Loading...

Videos from BNY Mellon Investment Management

Loading...

Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.