Sound Advice on Emotionally Intelligent Investing
Being aware of your emotions can help your performance in the stock market.
Posted August 24, 2012
My recent research on investing behavior with finance professors Terry Odean (U.C. Berkeley) and Brad Barber (U.C. Davis) suggests that emotions play a huge role in people’s investment decisions, whether they realize it or not. Quite simply, while research and rational thinking often play a role in investment choices, feelings of fear, guilt, regret, pride, trust and comfort can also hugely influence stock picking. Our research on this was published in a special issue on financial decision-making in the Journal of Marketing Research in November 2011.
Our findings support a string of prior research in behavioral finance that suggests that investors are often driven by their emotions to make choices that are not optimal for their financial well-being. This may be in part because investors are rarely in a position to predict the future performance of a stock. However, they do often intuitively know which transactions make them happier or sadder, more afraid or less afraid, more comfortable or less comfortable.
In our research, we reviewed over 700,000 actual stock purchases and found that investors are significantly more likely to 1) repurchase stocks previously sold for a gain rather than stocks they previously sold for a loss and 2) repurchase stocks that have lost rather than gained value since a prior sale.
These behaviors may make intuitive sense to you, but they are not particularly wise investment strategies. In fact, both patterns had marginally negative effects on returns, particularly when they caused investors to feel more comfortable trading more frequently. Indeed, much research has shown that frequent trading tends to lead to lower profits in the long-term.
So why do investors stumble into these behaviors that are not helpful to their financial performance? Well, the investment choices we observed were actually consistent with several psychological patterns that make sense in many contexts, just not with stocks.
Once Burned, Twice Shy
The first behavioral pattern I like to refer to as “once burned twice shy” and “you have been good to me so far.” If you made money on a stock before, you trust it to treat you well again. If you lost money on a stock before, you distrust it and think, “I am not going to let that one burn me again.” Fire hurts, so you avoid it. Chocolate is yummy, so you seek it out. The rule of sticking to what has been pleasant and avoiding what has hurt also makes sense for choosing which work colleagues to trust, which romantic partners to stick with, which restaurants to eat at, and which places to visit on a vacation. However, this heuristic (or general rule for making decisions) does not make sense when choosing stocks.
To explain: If you bought a stock in May and sold it in June for twice as much, but I, on the other hand, bought it in June and sold it for half as much in July, and now months have passed, and neither of us still own the stock, which one of us is more likely to see the stock price rise if we buy it today at 2 p.m.?
The answer is that we will both see the same performance if we buy the same stock at the same time, even though we each have a very different prior history with that stock. The stock will do the same thing in your portfolio that it will do in anyone else’s portfolio when that stock is purchased at the same time for the same price. Yet, two investors may feel very differently about the same stock based on their own personal experiences with that stock. Again, this is rational when choosing a restaurant, a friend, or even a mate, but not when choosing a stock.
Moral #1: Stocks are not like restaurants or friends. They are just stocks. One day they may be good to you. Another day they may burn you. Your past experience with a stock does not predict the future.
If you like a great restaurant, it makes sense to return to it. If you hated it, you should not go back. Similarly, if a former friend broke your heart repeatedly, it makes sense to avoid that person. If another has always been a source of support and good times, it makes sense to seek that person out. However, how a stock performed last time you owned it is not any more relevant than how it performed when you did not own it.
"It Could Have Been Worse"
The second pattern I like to call the “it could have been worse” phenomenon, which is when people prefer to buy a stock that has gone down since they sold it rather than up since they sold it. This is because even if they lose money on that stock, they will think to themselves, “at least I sold it at the higher price before I bought it back at the lower price. If I had just held onto it, I would have lost even more!” In a sense, buying a stock at a lower price than you initially paid for adds a silver lining to the final outcome.
This second common stock buying pattern is about reducing anticipated regret. As long as we can easily imagine a worse situation than the one we are in, we don’t feel quite as terrible about losing the money we lost! Of course, if the stock goes up after you buy it a second time, you feel even smarter for selling high and buying low. That said, discounts often make us buy things we should not buy.
Moral #2: We all love a good discount. However, it is important to remember that the share price going down is not always a sign of a better value.
When you combine the findings, our research illustrates ways in which investors choose what stocks they buy and sell in part to manage their own emotional well-being. The trick is to be aware of the patterns. It is fine to choose things that make you feel good as long as you recognize that this is part of your motivation. If you stay aware of the role of emotions in your decisions, you can do a better job making sure you don’t end up letting your emotions hurt your profits.
Moral #3: Do not ignore your emotions when investing. Instead, balance rational and emotional intelligence when making financial decisions.
Emotionally Healthy Investing
Money is not everything. Emotions do matter and should not be ignored. The end goal is not just to make money, but also to feel good and sleep well at night! So, for example, if you have a risky portfolio that is causing you to lose sleep, it is wise to lower your risk, even if your stockbroker tells you these investments have a good chance of paying off. Your physical and mental health is no less important than your financial well-being. In fact, when it comes to the point that worrying about your portfolio is endangering your health, it is likely time to make risk reduction a priority.
The key to doing well while staying happy and healthy is to be aware of your biases and make sure you are not letting your emotions take over to the point of irrational investing behavior. So what is the rational way to go when investing in the stock market? The most rational thing you can do is choose a highly diversified index fund with a low expense ratio, and put the majority of your stock investment dollars there, with the plan of investing for the long haul. Don’t invest money you will need in the near future. Don’t invest every cent you have. Just invest funds you won’t need anytime soon and/or funds you can afford to see dwindle substantially, should the market tank. Retirement money is perfect for this, assuming you are not retiring in the near future, as any losses will have a better chance of recovering over time. You can also take any money you can literally afford to lose (call it play money) and put that in individual stocks you believe in.
To preserve your health, wealth and sanity, don’t constantly monitor your portfolio. This may sound counter-intuitive, but the wisest financial scholars will tell you that in the absence of insider information, constant monitoring rarely leads to optimal decision-making. If you are invested in highly diversified index funds, you are not only likely to have higher and more stable returns over time, you are also likely to sleep better. Being highly diversified means that checking your portfolio often isn’t going to be necessary unless the market is doing something wild or you need to take money out for a needed expense.
Moral #4: Listen to both your rational head and your emotional heart.
Following Your Heart: Consider Socially Responsible Funds Aligned with Your Personal Values.
If you prefer to invest in socially responsible stocks, yet still want the diversity of an index fund, you can choose socially responsible index funds, which reduce the risk of loss as well as the guilt of investing in unethical companies, while minimizing expense fees. I am a big fan of these myself because they appeal to both the heart and the head. Such funds are diversified, so they are relatively safe compared to individual stocks, but monitored on social responsibility, so there is far less risk of supporting a company engaged in something that you consider harmful to society as a whole. Index funds also tend to have lower expense ratios than managed funds. Each fund has their own definition of social responsibility, so it is worthwhile to research the options out there to make sure your values and theirs are well aligned.
Moral #5: A healthy way to pay attention to both your heart and your head is to invest in highly diversified socially responsible funds that reflect your personal values and beliefs.
Of course, each investor has to choose what is best for him or her. My advice is to be aware of your heart and listen to the values you believe in, but use your head to keep yourself from making foolish decisions such as overtrading or taking risks you can’t really afford to take.
Happy Investing! --- Michal Ann Strahilevitz, Ph.D.
Referenced Journal Publication:
“Once Burned, Twice Shy: How Naive Learning, Counterfactuals, and Regret Affect the Repurchase of Stocks Previously Sold,” Michal Ann Strahilevitz, Terrance Odean, Brad Barber, Journal of Marketing Research, Special Issue on Financial Decision Making, November 2011, Vol. 48, pp. S102-S120
Useful Viewing and Reading: Relevant Media Interviews on Investor Psychology
Wall Street Journal article on emotions and investing by Jason Zweig. “The Intelligent Investor: Once Bitten, Twice Bold: Who’s Buying Stocks Now,” February 26, 2011
CNBC interview of my discussing joint research on investor psychology that I carried out with best-selling author Dan Ariely.
Other Media Quotes on Investor Psychology:
“Fear, Greed Produce Wild Ride for Stocks,” Saudi Gazette, (August 14, 2012)
“When does Repurchasing a Stock Make You Feel Good?” Mind over Market, (February 21, 2012)
“Investors Driven by Emotion, Not Facts” PsysOrg.com, (July 26, 2011)
“Buying the Same Stock - Again: Pride and Regret Drive Investors' Decisions” Haas School Newsroom, (June 01, 2011)
“Is It the Time to Say Good Bye to the Volatility?” Financial Times, (April, 2011)
“Stock Market Rally - Where's the Money Coming From? How Much is Left?” ETF Guide, (March 04, 2011)
“Buy high, Sell Low” The Chicago Financial Planner, (March 1, 2011)
“Investors Walking on Egg Shells” Seeking Alpha, (September 22, 2009)
“Some Investors Feel A Market Pullback” Sun-Sentinel, (September 18, 2009)
“Investors are Thrilled, yet Anxious About Stock Market Rally” LA Times, (September 17, 2009)
“Shiny Metal Shopping with Schiff, Rogers, and Faber” Investing Caffeine, (September, 2009)
“Stock Market's Recent Surge is Drawing Some Mixed Feelings” Omaha, (September, 27 2009)
“Treasury’s Waffling Rattles Confidence” The Street, (November, 12, 2008)
“Many Americans who Rode Previous Bears Lose Faith in Stocks” Press Democrat, (October 23, 2008)
“Investors Rethink Reliance on Stocks” LA Times, (October 22, 2008)
“Fear Greed Whiplash Stocks” LA Times, (October 11, 2008)
“Swaggers Turn to Shudders a Year after Market High” USA Today, (October 10, 2008)
“Stock Market Plunging into Pit of Despair” Michigan Live, (October 09, 2008)
“Bearing Up In a Bear Market” Cabot, (March 4, 2008)
Excellent Books Worth Reading If You Would Like to Learn More About Investor Psychology:
Ariely, D. (2012).The Honest Truth About Dishonesty: How We Lie To Everyone-Especially Ourselves. New York, NY: HarperCollins.
Zweig, J. (2007). Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich. New York, NY: Simon & Schuster.
Levitt, S., & Dubner, S. (2009). Super Freakonomics: Global Cooling, Patriotic Prostitutes, and Why Suicide Bombers Should Buy Life Insurance. New York, NY: HarperCollins Publishers.
Thaler, R., & Sunstein, C. (1999). Nudge: Improving Decisions About Health, Wealth, and Happiness. New York, NY: Penguin Books.