You've heard it before: Don't let your emotions take control. Instead, you're trained to take control of them. However, investors frequently find it difficult to apply that tactic to financial decisions.
Investing has always been tied to emotions. Impulses, just as they do with shopping, eating, and other areas of decision-making dictated by human nature, have an incredibly strong hold on investors. But if investors can understand these impulses, they can use emotions to their advantage and better position themselves for success.
Meir Statman, a professor at Santa Clara University's Leavey School of Business and author of What Investors Really Want: Know What Drives Investor Behavior and Make Smarter Financial Decisions, says many people talk about emotions as distractions and think they should be separated from investments. "You can't get emotions out of anything. And you shouldn't take all emotions out if you could," Statman says. "Most of the time, emotions guide us in the right direction."
One strong guiding emotion is sadness, which many psychologists have studied, including Ye Li, an assistant professor at the University of California--Riverside's School of Business Administration. Li co-authored a study released in November that examined how the sadness that typically follows investments gone sour influences a person's next financial decision. According to Li, hundreds of studies have examined the "sadder-but-wiser" hypothesis--that sad people make wiser decisions--and most find support for it. However, few tests of the hypothesis examined financial decisions, which he says are "some of the most frequent and consequential decisions people make."
Surprisingly, the results of Li's study found that sadness actually makes investors more likely to make brash decisions that will damage their portfolio. "It's about instant gratification," Li says. Sadness fosters impatience, propelling people to make investments they haven't taken time to think through. Rather than encourage a person to stop and analyze why their investing strategy failed, sadness causes a person to think of reasons they want to recoup that money now--and to act on that desire. For example, in the event a loved one passes away, Li says the beneficiary shouldn't immediately liquidate all the loved one's assets just because the beneficiary may want to use the money for an investment.
Although his finding didn't reinforce the "sadder-but-wiser" theory, it does support why there is so much concern over one of the most basic impulses: split decisions. "Don't react to short-term fluctuations in investment performance. These come with strong emotional baggage that can be quite misleading," says Paul Slovic, a psychology professor at the University of Oregon who began studying the interaction between emotions and decision-making in the financial world in 1972.
Like Li's study on sadness, a recent study on stress and investments revealed counterintuitive results. Mara Mather, a psychology and gerontology professor at the University of Southern California's Davis School of Gerontology, dug deeper into how the regions of the brain that factor into stress overlap with decision-making. "The results were striking for us," Mather says of the study, which found that stress, which is generally associated with negative events, would actually make an investor focus on the positive potential of a financial decision.
According to Mather's study, stress increases a person's levels of dopamine--the chemical that fuels reward-seeking behavior. Consequently, anxiety could make an investor mistakenly weigh a decision's risks and rewards. It could also make investors overlook blunders, since stress can shift one's focus away from unsuccessful investments. "You might be stressed out one day after getting bad news from the stock market, and in that case we would expect, based on these results, you might be paying attention to possible rewards," she says. "You'd be more focused on what trades you could make to recoup costs rather than dwell on the money that you lost."
Additionally, some people make numerous trades simply because they like the thrill of buying and selling investments. Others convince themselves they can look at their past investments and are therefore able to predict the course of the stock market. "Investors should know that hindsight errors lead them to the false belief that they can see clearly the direction of markets and the fate of investment in foresight, when in truth, they see them clearly only in hindsight," says Santa Clara University's Statman. "They should frame trading as [playing] tennis against a possibly better player than tennis against a practice wall."
Similar to life, the outcomes of investments cannot be controlled, but investors can give themselves an edge if they can find a way to utilize their emotions.
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