Emotions and How They Affect Investment Behavior

Recent times have been difficult for investors. Some have made the situation worse by buying and selling at the wrong times. For most people, the normal emotional response to rising markets is to feel confident and positive. This can lead to the desire to increase risk tolerance and purchase risky assets at potentially high prices. The opposite is true after big market declines. Our emotions may tell us to pull in and avoid risk when, perhaps, the opportunities for higher returns are greatest.

Because of this and other reasons, individual investors are notoriously bad market timers, as evidenced by mutual fund cash flows. For example, The Wall Street Journal recently reported that mutual fund research firm, Morningstar, determined that investors contributed more than $300 billion of new money to equity mutual funds during the six-year period from 2002 to 2007, much of it near market highs. When prices declined, investors redeemed more than $150 billion. According to the Hulbert Financial Digest, the total cost of this poor timing for stock fund investors was more than $42 billion for the 12 months ending May 31, 2009.

As a possible explanation of this behavior, we might consider the interesting work that is being done if the field of neuroscience, where researchers study the brain’s response to stimuli in an attempt to better understand human decision-making. Results are scientifically confirming what behavioral finance economists have suggested for some time: people are not hard-wired to be good investors because their emotions and other “normal” reactions can overtake their ability to reason rationally and make smart decisions under certain circumstances.

Brain scans show that there are two parts of the human brain operating in radically different ways. The prefrontal cortex is the rational, unemotional part of the brain that is used in long-term, logical thinking. The limbic system, on the other hand, is the brain’s short-term, emotional side that often causes trouble for investors. Under certain conditions, our emotional brains can take over and cause us to make poor, irrational decisions.

In a study published in 2005, researchers from Carnegie Mellon, the Stanford, and the University of Iowa, found that people with an impaired ability to experience emotions made better investment decisions in a simple investment game. The game involved a series of rounds in which players could choose whether or not to invest hypothetical money. Each round was structured to have a positive expected return on investment so that a rational player should choose to invest in every round, regardless of what happened in previous ones. Not surprisingly, the normal, unimpaired players were frequently affected by recent outcomes and were reluctant to invest after a series of losses. The players with impaired emotional function invested more regularly and performed better because they were less affected by fear and were more willing to take risk.

This was just a simple game with imaginary money. Imagine how this might play out more significantly in the real world with multiple sources of uncertainty and real money at stake.

Evolutionary biologists believe that humans developed this fear response as a survival mechanism to protect against predators. But in a world where we are not threatened by predators, this fear system can be over-sensitive, causing us to react to dangers that do not actually exist. This can lead to irrational choices and bad financial decisions.

What can investors do to neutralize the effects of their emotions and make smarter investment decisions? Here are some suggestions:

Stay Disciplined – putting too much emphasis on short-term market movements or popular, alarmist market forecasts might cause you to develop an irrational sense of fear. Turn off the investment “noise,” have faith that markets work, and stay committed to your long-term objectives.

Be Diversified – a properly balanced portfolio may smooth out the ups and downs, reducing the probability that big losses will send your short-term, emotional brain into overdrive.

Ignore the Recent Past – your brain is hard-wired to make projections based on past trends by seeking out patterns in data, even when none exist. This can be very dangerous to your financial health. Stay focused on the long run and ignore random, short-term fluctuations.

Write an Investment Policy Statement – you should develop and follow a comprehensive investment policy statement that outlines your important goals and a strategy to achieve them. Having a written policy makes it more likely you will follow a prudent path when your emotions tell you otherwise.

Rebalance – consistently repositioning your portfolio to target allocations is a time-tested way to keep your investment portfolio at a predetermined level of risk.

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