The Emotional Investor

Thinking & Feeling

• Our brain represents 2% of our body weight but consumes 20% of our energy
• The amygdala (in our brain) is our emotional center, whose purpose is to ensure our survival, and when faced with a threat will want to act quickly
  • This is why investors are influenced react hastily to surprise events (threat to system with desire to act immediately)
• Our pre-frontal cortex is our thinking brain – where we handle executive functions such as planning and reason
• When it comes to decision-making, best to categorize the brain as Reflexive and Reflective (aka System 1 and 2)
• Our Reflexive system is the default responder; immediate, automatic, and effortless
  • Influenced by feelings, mental shortcuts, and intuition
• Our Reflective system requires purposeful thought, attention, and effort
  • Engages the pre-frontal cortex
  • This is where we want all financial decisions made
• We need to override the automatic and natural emotional response and purposely engage the prefrontal cortex so we can think rationally about the situation at hand

Volatile Market, Volatile Behavior

• Market volatility doesn’t cause investor losses; it is our response to market volatility that can cause loss
• Downside volatility (loss) can activate the amygdala, which it views as a threat, and responds with, “Get to safety. Sell…Now!”
• Volatility is an inherent feature and function of stock markets
• We cannot control the market’s volatility, but we can reduce its effects on us
  • Make volatility subjective by not looking at the market
  • By watching and evaluating performance less frequently, we reduce the volatility we personally experience
• We can take a more productive perspective by realizing that downside volatility (loss) provides opportunity to buy low
  • All investors say they want to buy low – this is the only way to get it
  • This allows disciplined investors to take advantage of asset mispricings caused by emotional and directionless investors
• Volatility, while uncomfortable, helps remind us there are risks and to focus on the long term
  • Volatility largely exists in over short period of time (tends to smooth out over longer periods of time)

Myopic Thinking

• “Over a short time increment, one observes the variability of the portfolio, not the returns.” – Nassim Taleb
• Short term outcomes are not reliable indicators to the wisdom of an investment nor it’s long-term potential (performance)
• Some of the most successful long-term stocks today experienced many significant pullbacks over the years
  • Great long term assets can have periods of time when they perform very poorly
• Investing in the short term is dominated by noise and random outcomes
  • Do we really want to invest based on information that could change on a dime? That is more like speculating
• Strategic procrastination – choosing not to react – can be a helpful strategy during different times
• Discipline to a customized and written plan is often the best advice

Illusion of Certainty

• Our brains may be made of gray matter, but they hate gray areas
• When faced with uncertainty, the brain (unconsciously) seeks any information to help it understand the future, and often falls for the illusion of certainty
• Hearing an “expert” makes us more likely to believe, but expert forecasts, while filled with confidence, lack accuracy and consistently
  • Historically “expert” forecasts are right only about half the time
• The question is not one of information or intelligence. The question is one of predictability.
  • Are the markets and economies predictable or not?  (Hint: They are not!)
• When considering a forecast, be sure to also consider what if they opposite happens
  • This is why following a plan is so beneficial, it takes the need to identify accurate forecasts out of the equation

Illusion of Control

• The unpredictable and random nature of stock market performance, and our desire to control outcomes, makes us susceptible to the illusion of control
• Illusion of control is often demonstrated through micromanaging the portfolio and trading frequently
  • Trading and “making adjustments” make us feel like we are doing something good for our money
• Investing is a combination of skill and luck – identifying the difference between the two is essential
  • Skill is often demonstrated through patience and discipline to an investment plan/strategy
  • Luck is what happens due to factors outside our control or expectation
• If the market goes up on average, then we need to give it enough time for the average to occur

News & Noise

• The media’s primary role is to sell ads – not to help investors make wise decisions
  • So they need viewers and clicks (that is their end goal)
• Hyperbole, sensationalism, and emotional triggers are often used to get people to tune in, and stay tuned in
• These same tactics produce an incredible amount of noise that often distracts and hurts long-term investors
• “Additional information” is not always helpful – especially if the information is contrary to investor goals (i.e. short term info)
• Before making any investment decision consider where the idea came from and discuss with your advisor

Overconfidence

• “The road to investing hell is paved with overconfidence.” – Jason Zweig
• Optimism and overconfidence can lead investors to underestimate the risk and potential downside of investment options
• Increased information breeds excess confidence, but doesn’t result in more accurate decisions
• Investors should identify the limit of their expertise and predictive abilities (should also recognize these same limitations of experts)
• Remembering and learning from past mistakes can help us be more thoughtful with future decisions
• Creating a pro/con list can help us seek out potential downsides of an investment/strategy – so we are thinking about all aspects of it

Reference Points

• Whenever we are trying to estimate something (future return, outcome of an event) we are unconsciously influenced by reference points (anchoring)
• Reference points can be an expected return, future value of the market, or even feelings
  • When we feel good now, we project it far into the future. Same when we feel bad (this may be one reason why markets tend to overshoot to the upside and downside)
• We need to realize that most predictions (even expert predictions) are nothing more than a summary of what just happened
  • Whether we know it or not, our views of the future are often very similar to the current situation
• It is important to engage the reflective brain to ensure we are thinking about all information and we are not being influenced by easily available reference points
• Rather than expect one average rate of return for the future (i.e. 8% per year), it is more helpful to expect a range of returns your portfolio is likely to experience (i.e. -25% to +33%)

The Pain of Loss

• Most investors are affected by loss aversion – the fact that losses weigh heavier on us than joy of an equal size gain
  • Studies say we feel losses 2x as much, but this is subjective. Some may feel it much worse
• Loss averse behavior causes investors to sell their winners (lock in the gains) and ride their losers (to avoid a loss in hopes it will come back)
  • This is opposite behavior as a stock index which trims their losers and rides the winners over time
• Loss aversion is accounted for in the portfolio recommendation / investment strategy
• For investors with significant loss aversion, strategies that offer a guarantee may be attractive (even though more expensive)
  • Put options
  • VA with protective riders

Perception

• Our perception, which is created by past experiences and current beliefs, drives our decisions
• Our perception is our reality – which can be skewed or incorrect
  • “The market is rigged” is a common misperception based on a past experience
• Advisors need to understand investor perception and correct when necessary
  • Behavioral coaching is all about correcting perceptions and ensuring realistic expectations

Final Thoughts

• Emotional investing feels good, but thoughtful investing is good
• Having a written plan that states purposes, goals, risk, and planned responses to market conditions (pre-commit) can help investors hang in there during difficult market environments
• One of the greatest values of a financial advisor is for investors to discuss investment options, reasons for them, feelings, and potential outcomes
  • Advisors are a sounding board and ensure that your decisions are in line with your plan