How Emotions
Influence Investment Decisions

By Dr. Richard Geist, editor
Strategic Investing

       As psychologists, we often argue that the traditional investing notion of "parking your emotions at the door" when making investment decisions is paradoxically the exact wrong thing to do; it leads to more mistakes than allowing yourself to remain aware of those emotions, and using them to influence your investment decisions. Or, on a grand level, allowing them to influence macroeconomic policy.
       Traditional economists have always been uncomfortable with such soft notions, preferring to believe that humans are rational beings who make logical, deductive decisions which "maximize utility" or value. And, because economists had no way of measuring the subjective concept of value, they used the only tools they had - statistics such as productivity, income, savings or spending patterns to determine investor value preferences. But these concepts don't necessarily tell us much about how people subjectively experience the world, nor how they use their emotional convictions to make decisions. It was because of such subjectivity that Benjamin Graham suggested that it was impossible to value young emerging growth companies according to any quantitative methodology and that we shouldn't even try. Although several decades of research is finally convincing folks that emotions may have something to do with decision-making at both the micro and macro level, investors are asking (and rightly so) for the practical implications of this research. So here are a few ways emotions can be helpful to your investing judgments.

Understanding The Context

       Emotions enable you to see things that others cannot discern. George Klein, the cognitive psychologist, gives a wonderful example of this in his book Sources of Power. He uses the analogy of two different diseases that can affect our vision: macular degeneration and retinitis pigmentosa. In the first, the central part of the retina is destroyed and we can't see what is directly in our line of vision; in the second, we maintain the ability to see what's directly in front of us, but lose our peripheral vision. At first, Klein thought that macular degeneration would be the worst disease to have, as it seems logical that we can compensate for peripheral vision. But to understand why he was mistaken, he performed a simple experiment. Hold your raised thumb out in front of you and focus on the thumbnail. This is the part of your vision that is lost due to the early stages of macular degeneration. Whatever else you see is part of your peripheral vision. If you lost this peripheral vision, you would be stuck focusing on each individual part with no context. Klein compares this to being hyper-rational - "the attempt to apply deductive and statistical reasoning and analysis to situations where they do not apply." Although he doesn't take the next step, it is clear that the context (the surrounding emotions) have a major impact on the analysis of our central focus. This is akin to understanding that our capacity to assume risk is not static, as financial thinkers have often assumed, but rather depends on current relationships, support systems, safety nets, and inner resources, all of which are constantly changing in terms of their emotional impact on us.
Intuition Is Impossible

Without Emotion

       Of 256 CFAs surveyed by Bob Olsen at Decision Research, 89% of them agreed with the idea that quantitative valuation models are less useful in analyzing securities of new and more volatile companies. And 64% of them agreed with the statement that as forecasting recommendation tasks become more complex and difficult, they tend to rely more on judgment and less on formal quantitative analysis. Intuition is an emotional reaction to a current day situation based on unrecognized past experiential patterns. We use intuition to size up a situation without quite being aware of the past experiences with which we are comparing it. These experiences are nearly always tinged with emotion and it is frequently those affects that are embedded in our unconscious memories that are subtly evoked in the present situation. For example, stock market predictions are often intuitively based on past emotional experiences that are rekindled by similar, but slightly different, feelings in the present. Of course, these predictions are always couched in hyper-rational terms because otherwise they wouldn't be believable.

Emotions As Signals

       I have a friend who is a commodities trader for a major money management firm. When talking about computers and trading systems he likes to use the analogy of a dog whistle to point out how the computer enables us to see certain patterns that typically remain hidden - just like the dog whistle is audible to our canine friends, but not to us. Emotions are similar, for they provide us with useful signals to unconsciously anticipated events. If, for example, you keep track of your emotional reactions to what various CEOs say on a conference call, and then follow the company for several months, you will discover a pattern that equates certain of your emotional reactions with the subsequent unfolding of events at the company. You will learn to recognize, for example, as one investor told me, "every time I seem to have confidence in what a CEO says, something goes wrong. But, when I've found myself feeling more skeptical of what he says, everything seems to turn out OK." This is not a reaction shared by everyone because such emotional reactions are highly idiosyncratic, but the important point is to begin to discover these highly personal reactions and then use them as signals that can supplement your more rational research and reactions.

Clues To Investing Style

        There are numerous styles of investing, each one embraced by a disparate subset of investors. Cocktail party conversation suggests that each of these subsets thinks their style is the only reasonable one to pursue. We know from talking with investors, however, that when there is a general fit between investor personality and investing style, individuals feel more confident in their decision-making and are usually convinced that their way is the only way to success.
        Furthermore, when there is a reasonable congruence between personality and investing style, anecdotal evidence suggests that investors experience greater success in the market and generally feel better about their decisions. What enables this fit to occur is an awareness of our own emotional style. For example, those of us who get excited about and value hitting a home run often end up eschewing wide diversification in favor of making large bets on a few well-researched opportunities. Charlie Munger and Warren Buffett are the most well known advocates of this school of investing. Those of us who feel emotionally more uplifted by hitting singles and doubles tend to be more widely diversified and enjoy the safety of a more balanced approach to the market. There is no correct investing style, but there is generally a correct match between investing style and personality. Only by becoming aware of our emotional reactions can we achieve this fit. Without having access to emotions, we generally embrace someone else's theory of the best investing style, or even worse, we embrace the herd's latest fad.
        Emotions have always been the driving force in individuals' lives. Sometimes these emotions appear rational; other times they appear irrational. In all cases, they are subjective and available to enhance not only our life decisions, but our investment decisions, when we take the time to reflect on them.
        Editor's Note: Dr. Richard Geist is on the faculty of Harvard Medical School's department of psychiatry and is president of the Institute of Psychology and Investing, where he consults with brokerage firms, money managers, financial planners, individuals, and small companies. He is also publisher of the micro-cap market newsletter, Richard Geist's Strategic Investing, 1905 Beacon St., Waban, MA 02468, 1 year, 12 issues, $157. His recently published book, Investor Therapy, is now available in bookstores and on Amazon.com, and barnesandnoble.com.