- Understanding behaviour and individual emotions can lead to better investment decisions.
- See emotions as a dataset and compartmentalise feelings for greater clarity.
- Categorising emotions leads to greater intuition and conviction levels – traits of successful leaders.
Why Behavioural Finance Matters
There are many ways of becoming a successful investor. Learning how to build the appropriate portfolio and determining your risk tolerance are key aspects. However, there is one skill, often overlooked, that distinguishes between a ‘good’ investor and a ‘bad’ investor: understanding behaviour. Researchers are increasingly turning to the psychology of investing to understand how we can make better investment decisions, arguing that investment is 80% psychology.
Most investors assume their decisions are informed by their personal preferences, using rational choice to achieve outcomes. This is known as rational actor theory (RAT). It argues investors are consistent in their decision-making and therefore act logically when deciding to buy or sell. But is RAT reliable?
The figures suggest not. Financial research firm Dalbar found that the typical equity investor earned 5.35% less than the S&P 500 in 2019. The reason, it argues, is that many investors act imprudently, withdrawing their money during market crises in a state of panic. In other words, investors are more likely to react to short-term market movements – no doubt influenced by their emotions – rather than strategizing for the long term.
So how can we master our behavioural pitfalls?
Emotions Should Not Be Left to the Gutter
The problem with RAT is that it assumes rationality is a given and that rational choices are based on ‘error-free calculations’. It does not factor in human emotions and impulsiveness, which are inherent characteristics of the human psyche. Accordingly, researchers are now pointing to the importance of emotions.
We spoke to Founder and CEO of ReThink, Denise Shull, about it all. She argues that the most effective way of becoming a rational investor is to create a dataset of your emotions and analyse them. The journey to making an investment decision may feel unorganised. You probably recognize the roller coaster of emotions below (Chart 1). But do not lose hope. Breaking down the process and noting your feelings throughout the different stages is the first step to recognising how your emotions affect your decisions.
‘we think we make decisions based on our analysis. We think we make decisions based on how we’ve learned to understand the market and then we do this analysis and we make this prediction. That’s actually not what we make the decision on. We make the decision on our confidence in that analysis.’
This reliance on our confidence often leaves us vulnerable to confirmation bias. This is the act of supporting our own opinions and world views by seeking selective information that ‘confirms’ these assumptions and, dangerously, builds our confidence in a decision. The real challenge is to recognise this confirmation bias and to seek contradicting information that challenges our assumptions.
Harvard psychologist Jennifer Lerner categorises emotions into ‘integral’ and ‘incidental’. The clue to knowing what integral emotions are is in the name – they are integral to decision making. Think of integral emotions as something like anxiety. When making a risky investment decision, your sense of anxiety about volatility is integral to your judgment. And it is a rational component of decision making.
On the other hand, incidental emotions are those that impair our judgment. They are the emotions triggered by past situations that carry over to future ones to influence a decision, even though they have nothing to do with it. For example, you might have had an argument earlier in the day that puts you in a bad mood, influencing subsequent choices – like not to go to the gym.
Researchers argue most investment decisions are influenced by incidental emotions. For investors, Shull suggests categorising emotions into informational vs irrelevant, or intuition (true pattern recognition) vs impulse. Her advice is to
‘…write down every word [you] can think of for a feeling or emotion of trading and investing, see how many there are, because the research shows that the more words you have for these physical experiences, the more you can get the information out of them and the more you’re likely to not act impulsively. So, I always summarise this into the question of what am I feeling and why?’
This allows you to pull out your ‘true intuition’, start to recognise patterns, and tolerate the anxiety of decision making. Ultimately, this will lead you to greater conviction levels.
What can investors take away from this? The main aspects to remember are to find time to write out what you are feeling and really dig deep into understanding why. This can lead to better intuition and conviction, traits considered to be those of successful investors. Unravelling the unconscious emotional drivers and past emotional narratives that influence and cloud our judgments is the first step to attaining better clarity and controlling your emotions.