Investors May Let Emotions Drive Decisions

I found this excellent article, “Investors May Let Emotions Drive Decisions” on The Mess That Greenspan Made.

Much of economic and financial theory is based on the notion that individuals act rationally and consider all available information in the decision-making process. However, researchers have uncovered a surprisingly large amount of evidence that this is frequently not the case,” Tilson wrote in a paper called “Psychology & Behavioral Finance.”

One problem: We’re too emotional. A study published in “Psychological Science” co-authored by professors at Stanford University, Carnegie Mellon University and University of Iowa pitted people with normal brains against people whose limbic systems, the brain’s emotional center, were impaired.

The paper asks whether a neural systems dysfunction that curbs emotion can lead, in some circumstances, to more advantageous decisions. The answer, in terms of investing, was yes.

In the study, people were given $20 in play money and could invest it $1 at at time. Winning or losing was decided by a coin toss, the winners would win $2.50, more than tripling their initial investment. The losers would lose the dollar they invested. The odds were clearly in the investors favour. Yet the people with normal brains became more conservative after losing. The people with impaired limbic systems did not.

“Medical study confirms brain impairment HELPS improve investment returns,” Ajay Singh Kapur, chief global equity strategist at Citigroup, wrote in a summary of the study.

He uses the study as an argument for fighting instinct and getting into the market when investment sentiment is most negative and exiting when investor sentiment is high.

Benjamin Graham talks a lot about NOT thinking too hard when it comes to investing (unless you make it your full-time job like him) and keeping a simple, conservative approach: “It is no difficult trick to bring a great deal of energy, study, and native ability into Wall Street and to end up with losses instead of profits.” As well, there is the quote I gave at the bottom of this article.

This is one of the key aspects of the Intelligent Investor, “harnessing your emotions.” In the commentary for the Introduction, Jason Zweig writes:

What exactly does Graham mean by an “intelligent” investor? Back in the first edition of this book, Graham defines the term–and he makes it clear that this kind of intelligence has nothing to do with IQ or SAT scores. It simply means being patient, disciplined, and eager to learn; you must also be able to harness your emotions and think for yourself.”

2 thoughts on “Investors May Let Emotions Drive Decisions”

  1. That’s true, investors have to be in control of their emotions when investing. They cannot let fear and greed get in the way. That is why a lot of people buy high and sell low. They get on the bandwagon when people think the market will go up forever, then when there’s a bear market, they panic and sell along with all the others. Behavioral finance is a very interesting subject.

  2. It’s great that this behaviour is so ingrained in human nature. It means that those who control their emotions and behaviours should be able to do better than those don’t. If people weren’t selling when stocks were low (and in turn driving stocks lower), clearer heads wouldn’t be able to get in there and buy low.

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