Editor’s Note: When the end-of-year holidays roll around, we like to revisit an assortment of “best of” pieces taken from throughout the year. And what a year it has been. Given the degree to which 2020 has been mentally taxing for almost everyone, it seems fitting to revisit the topic of mental versus financial capital, and the reasons why both are equally important. — JCL
Investment success depends on two types of capital, financial and mental.
We are all familiar with financial capital. This is what goes in the brokerage account. Financial capital is what we use to buy and sell stocks, options, cryptocurrencies, or whatever it is.
Mental capital, though less well known, is just as important.
Without mental capital, financial capital is useless. The wise investor practices risk management not just with financial capital, but mental capital, too.
So, what is mental capital, exactly? There are different ways to define it. But three key areas of mental capital are emotional resilience, decision-making energy, and decision-making consistency.
Emotional resilience is about holding up well in times of stress. (Like right now.) The more emotional resilience you have, the better you can handle volatility and uncertainty.
There is a tongue-in-cheek saying, “blessed are the flexible, for they will not be bent out of shape.” Emotional resilience is the ability to be uncomfortable, or get pushed out of your comfort zone, and then spring back to positive form.
Decision-making energy, the second component of mental capital, is exactly what it sounds like. It is the amount of mental energy you have in reserve to make hard decisions, or to make a long series of decisions.
If you’ve ever had that feeling at the end of the day where you can’t decide what TV show to watch, let alone what to have for dinner, you know what it’s like for your reserves to be depleted.
In the field of neuropsychology there is a phenomenon known as “directed attention fatigue,” or DAF for short. DAF is a sense of mental tiredness that comes from fighting off distractions.
The harder you have to concentrate in order to pay attention, even as stimuli, emotions, and interruptions are flying all around, the more fatigued your mind becomes.
This also explains why mental capital gets depleted in high-volatility, high-stress environments. When anxiety levels are high, the distractions are internal. Your own brain, wired up by adrenaline, becomes an agent of self-distraction.
The distractions triggered by your own careening emotions then cause DAF — directed attention fatigue — as it gets harder and harder to maintain focus, and your ability to make decisions disappears.
This leads to the third component of mental capital, decision-making consistency.
Decision-making consistency is a measure of how well you follow your own rules.
Picture two investors using the same system to manage position risk. Both investors are committed to “always following the rules,” meaning, they fully intend to abide by the system.
If the first investor actually does this 100 times out of 100, their decision-making consistency is perfect. If the second investor does it half the time, but blows off the rule 50% of the time, their decision-making consistency is terrible (no better than a coin flip).
As with so many other things, it’s harder to be consistent in times of volatility and stress. The more that our emotions get tested, the harder it is to stay disciplined.
As a side note, this is where “stress eating” comes from: The temptation to indulge is constant, but under stress, the ability to resist is weakened.
It’s all connected: Emotional resilience makes it easier to preserve and replenish decision-making energy, which in turn enables decision-making consistency. And when mental or physical energy levels get depleted, the clarity and quality of decisions degrades, too.
So how do you preserve mental capital, or replenish reserves when mental capital is low?
The No. 1 thing is simple but profound: Be sure to get enough sleep.
Sleep has been described as “the Swiss Army knife of health” because physical rest is a key component of so many processes. When you sleep, your body heals and your mind cleans up, in terms of flushing out toxins while consolidating memories and digesting the lessons of the day.
It is often the case that, when mental capital is depleted — when emotions are raw, the mind is fuzzy, and decision-making capability is poor — physical rest is the most immediate remedy.
There are many other ways to build and replenish mental capital. In the broader sense, it’s a topic that could fill a thousand books, but a good first step in these wild times is simply remembering that mental capital is important.
If you find yourself feeling irritated or anxious, get a change of scenery and a good night’s sleep. You might be surprised what a difference it can make.
And if you aren’t doing so already, try to spend as much time thinking about mental capital — your own psychological health and well-being, and capacity for good decision-making — as you do thinking about financial capital (the stuff in the brokerage account).
You just might find yourself on a smoother investing path, with more success, less internal stress, and a heightened quality of life as a result.