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Investing, With a Side of Emotion

“Don’t let emotion drive your financial decisions.

We hear this line, or a version of it, from investment pundits all the time. During times of market volatility it is even more prevalent.  Is it realistic though? Is it possible to remove emotion from these types of decisions? And more importantly, should emotion play a role in our financial lives?

As humans, emotion drives the majority of the things we do and decisions we make in our lives.  We are inherently emotional beings. So if that is the case why do so many think it should be removed from the financial part of our life. The main argument is that emotion can often prevent us from thinking rationally about specific financial decisions. Greed and fear can creep into these decisions and prevent even the most educated investor from making the thoughtful choice.  I’m not saying I disagree with this argument and I find that many of the clients I work with struggle with these emotions when making financial decisions.  I will even go a step further and say a number of my clients hired me specifically to prevent them from making emotional investment decisions.  With that said, I do not think emotion should be removed from the financial planning and investment process. I actually think it should be embraced. The important thing to decide and understand is where emotion fits into the process and what role it should play.

So what is that role? Speaking with clients and prospects every day I find that emotion tends to be ever present throughout the planning and decision making process but too often it is present in the wrong part of the process.  Clients are scared that the market went down, so they want to sell.  They are excited that the market is going up, so the want to buy more.  This is a sign that emotion is getting involved in the wrong part of the process.

In initial client/prospect meetings, my goal is always to explore the emotions of the client.  I seek to understand why they are saving, what they are trying to accomplish and what is their goal for investing at all. When any individual is making the decision to start saving, to start investing, this is the time you should get emotional.  You should picture your future.  You should dream about where you want to be in 1, 10 or 30 years.  You should use emotion to understand the “why” behind your investing and financial planning. Without this emotional foundation, any planning or investing will lack true motivation and purpose.

When you understand why you are investing and where you want to be, the next step is to try to quantify this emotional reaction.  What do you need to do in order to reach those goals?  How much do you need to save?  What level of risk are you comfortable with?  What are the numbers behind what you want to accomplish? These are all questions where emotion will play a key role and the answers to these questions will create a framework to eventually make decisions.  Some people are able to do this step on their own, others hire an expert to help them understand this step, but the important part is making sure that you embrace emotion during these early stages of the financial planning and investing process.  Without fully understanding the why behind your investing it is very easy to get bogged down in the daily or weekly performance of your investments or plan. You start to question yourself and your process. You then allow emotion to creep into the next step of the investment process.  And this can be disastrous.

Once the goals, dreams and other emotional reactions are quantified the final step is making the actual financial decisions. At this point emotion needs to take a backseat. Stocks and bonds are not emotional.  They don’t perform emotionally. They don’t have dreams.  Their prices move and fluctuate based on investors’ perceived value of the underlying securities which is based on all available information about that security (or at least that is what the Efficient Market Hypothesis would lead us to believe).  So specific decisions about what, when and how to buy and sell need to be made without the influence of emotion.  At this point a well thought out, disciplined investment approach is king. Do this on your own, hire an advisor, whatever you need to do to keep emotion from creeping into this part of the process. As I said earlier, failure to do so can be disastrous. This can be illustrated by the lag in investment performance felt by the ordinary investor.  As Dalbar’s annual report on investor returns points out, as of the end of 2014 the average equity mutual fund investor saw an annualized return of 5.19% for the previous 20 year period while the S&P had an annualized return of 9.8% over that same time period.

It is naïve to think that investing and planning is this simple.  As I said at the beginning, we are emotional beings.  It is inevitable that emotion will find its way back in.  There will be that day when the market is up big and you think to yourself if you can just capture a bit more of the upside then you can buy that house sooner or retire more comfortably. Or that day that the market is getting crushed and you see that retirement date moving further and further into the future.  When this happens, all investors and advisors alike need to take a step back and remember where in the process these emotions belong.  This is the time to revisit the “why” behind investing. Go back to earlier in the process and see what your new emotions are telling you about why to invest or plan. Understand again what future you are saving for. If you are feeling stress or fear about losses or find yourself wanting more returns than you probably made a mistake quantifying the emotions around your risk tolerance at the start of the process. If any of this retrospection causes changes in your initial goals, then make the necessary changes and adjustments in those quantifications. Then proceed to the decision making process, with emotion again riding in the backseat.

The pundits should really say: “Don’t let emotion drive your financial decisions, but embrace it along the way.”

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Trackbacks & Pingbacks

  1. […] let volatility or any other variables force them into making a quick, emotional decision.  Emotion can be a very powerful force in all aspects of life but should be moved to the side when making financial decisions.  Emotion can easily cloud […]

  2. […] motivating yourself to save.  You are motivating yourself to retire early or buy that house.  These emotional connections to your resolutions help to improve motivation and make you more accountable because not achieving […]

  3. […] the investment world it is very easy to let emotion get in the way of making a rational decision. Emotion should play some role in the planning process but when it comes time to make a final decisions, facts and rationality should be the driving […]

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