In many ways, emotions are life’s seasoning; they spice up what might be bland or dull. Like spice, they may get out of control before you know it.
There are some things you just don’t add spice to, like ice cream. Or investing.
Emotions drive many of our behaviors. When it comes to investing, emotions tend to affect our decision making and frequently drive us places we shouldn’t go, like selling investments at a loss or purchasing them at or near peak prices.
Emotions are not going to separate themselves from the process. If we want better investment decisions — decisions free from FOMO and whim — then we need to take control and place reason over emotion.
Easier said than done.
The Telltale Signs of Emotions Affecting Decision Making
Exuberance has no place in investing. It is one of the telltale signs.
When the press and other investors talk about new paradigms and reasons why this time is different, many people follow the herd. They have done it time and time again.
It happened with internet stocks, in what became known as the internet bubble. The media said that companies didn’t need to make money to be valuable. It was a new paradigm.
That bubble burst. People who followed the herd followed it off the cliff. Many people bought the hype and lost their shirts. That’s an example of mass exuberance, but it doesn’t need to happen that way.
People often convince themselves that there’s an investment that can’t lose. They got a feeling, or a hot tip. They listen to emotion and forget reason. That scenario rarely has a happy ending.
Panic is the other side of the same coin. A drop in the market is not a reason to sell. It is more likely a reason to buy. But people will sell their blue-chip stocks because some tech stocks had a rough couple of days.
There’s likely no relationship, but panic selling fuels panic selling just like irrational expectations fuel irrational expectations and cause people to pay outrageous prices for things that just are not worth it.
Trends in the overall market are not something to follow with your money. That’s a telltale sign.
When you are doing something because everyone else is doing it or it seems too good to be true, it probably won’t end well.
Buying things when they are too high is part of the problem; selling when they are low is another problem.
If you look at major market declines, outflows tend to peak near the bottom. Just when things are as low as they are going to go, that’s when there’s a spike in people selling. That is what it looks like when emotions affect how your decision making works. And when emotions drive, your portfolio may soon need resuscitation.
Our Behaviors Are Problematic, Too
We don’t always follow the herd off the cliff — sometimes we go there alone. We are not programmed well for rational investing.
Humans are programmed for loss aversion. As a rule, we would find the pain of losing a dollar much stronger than the pleasure of gaining one.
When faced with the likelihood of losing money, we tend to make poor decisions — unreasonable decisions — to try to avoid the loss. We double down when things are not going our way.
This is what causes people to break out a credit card when they are down at the casino. They can’t tolerate the thought of loss, so they take unreasonable risks to try to recoup the loss. In investing, this may look like taking on more risk when things are not going well. Not a reasonable choice.
That’s one of our big problems with investing. We need to make rational decisions, but our evolutionary makeup programmed us for different situations.
Anchoring is when we adopt the first piece of information we hear and place undo weight on it. We may hear that a company is going to be coming out with a hot new product, or planning to release new and exciting features for an existing product.
We might later hear that there are significant problems with their anticipated launch, but discount that information due to the anchoring of the earlier.
Confirmation bias is when we seek out information that supports our plan or point of view. Sounds more like politics than investing, doesn’t it? Seriously, when we seek out information that confirms what we already believe, then we are not going to make an objective decision. And a nonobjective decision is a suboptimal decision.
Overconfidence is more of a detriment to successful investing than underconfidence is. Overconfidence leads to people making uninformed decisions because they think they know more than they do. They will jump into an investment without sufficient research because they are sure they know what they are doing.
Underconfident people may wait too long to go in, but are more likely to invest for solid reasons — they wouldn’t do otherwise. Overconfident people over-trade and lower their returns and increase their costs.
Timidity can cost you if you stay on the sidelines too long or don’t take sufficient risk to achieve your goals. But an equal amount of overconfidence will cause more damage than underconfidence will.
How to Manage Emotions in Decision Making
The goal is not to become an unemotional person; the goal is to know where we fail and take steps to prevent our emotions from driving us to suboptimal behaviors.
And we can do this.
There are two approaches we should employ. We need to be cognizant of our biases, so we can minimize their effects. And we need to employ a process that drives our investment decisions, reducing the number of potentially emotional decisions that we make.
Being cognizant of biases can reduce, but not eliminate, their negative impacts. Knowing we tend to make bad decisions when faced with a potential loss may reduce the number of times we make bad decisions or the magnitude of those bad decisions, but the issue won’t go away. We don’t seem to be able to get full clarity and control where emotions and behavior intersect.
Likewise, cognizance of anchoring, confirmation, and overconfidence biases can help us reduce their frequency and severity, but they won’t go away. And there are more; we need to be cognizant of a rather extensive list of biases if we want to eradicate as much of their negative affect as possible.
Beyond directly managing our emotional response, we need to employ a system for making investment decisions and managing investments.
A Systems Approach to Investing
Using a model portfolio or asset allocation model can be a solid basis for avoiding letting emotion affect your decision making, which will help prevent investing mistakes. Properly used, these models use rules to determine when and what to sell or buy, at least on an asset class level. This takes much of the decision-making out of our hands.
A portfolio tool should be used with a mechanism that triggers when to rebalance. Some people prefer to rebalance when a portfolio deviates from its intended allocation by a predetermined percentage. Others like to rebalance based on a fixed schedule, such as quarterly.
Most choose the method they feel is least likely to miss a significant change that falls just under or outside of the rebalancing trigger.
For example, if an investor is using a percentage method, they would miss rebalancing when changes fall just short of the triggering percentage, and potential opportunity can be lost. Or an opportunity may come and be gone within a quarter, and the investor will likewise miss a potential opportunity.
These are, overall, minor risks. A major advantage of using a portfolio model is that it keeps the investor from chasing fads and short-term trends, which is what some are afraid they are missing. It leads you to sell high and buy low, which most won’t do without outside help.
A structured portfolio methodology is a key to avoiding emotion-based investment decisions.
When faced with a hot tip, you know you have to pass because it’s not time to rebalance or you don’t need to increase that asset class at this time. Crisis avoided.
A portfolio model does not, however, make the investment selections for you. You need a system there as well. A system that guides you in your choices so that emotions do not affect how your decision-making works.
You have options here, depending on your investment philosophy and what you believe works or have found to work in the past.
Technical analysis can be a great toolset. If you have established criteria for what you will bring into your portfolio within a given asset class, then you have cut the potential for decision making that's affected by emotions.
Value investing is also a solid option. Buying assets that are undervalued in the market will generally exclude buying into trends or fads; value investments simply are not found in those places.
Value investments may not have the charisma of some other opportunities, but charisma is not something you get to spend on your goals; you need appreciation, and value has historically been a source of appreciation.
You can use other approaches; an approach where you have a system for objectively selecting investments reduces the subjectivity that comes with decision making affected by emotions that tends to hurt performance.
The Bottom Line on How Emotions Affect Your Decision Making
Humans are imperfect in many ways, and evolution does not seem to have prepared us for the long-term mindset necessary for successful investing.
But though we are fallible, we are also kind of smart. We can choose better, if we understand our challenges and stop our emotions from affecting our decision making.
If we are aware that we tend to make suboptimal decisions due to our biases, we can take steps to reduce their impact.
And we can put processes and rules into place so that we put our investments to work and let them do what they are supposed to do. We take on the role of investment manager, but we don’t micromanage. We stand back and step in when the triggers tell us we need to act. And then we act in a consistent, predictable, predetermined fashion.
The result of removing our human fallibility from our investment decisions is that our investments tend to do better. When we are too hands on, we tend to take more actions that hinder than help. We simply need to have awareness and a solid process so we can enjoy our investment growth over time without the stress those micromanagers must feel.