Making financial decisions is difficult to begin with—even more so when we let our emotions get in the way.
“Greed is good,” says Gordon Gekko in the movie Wall Street.
Although I would not go quite that far, greed is a natural human emotion. A Wall Street adage states that two factors move the market: fear and greed. This perception is fueled partly by the media and partly by reporters who wish to be dramatic but may not fully understand what truly drives the market. While ideas of fear and greed have dramatic potential, the characterization is far too simplistic. The human mind is too sophisticated, and human emotions too complex for fear and greed to adequately describe the psychology that affects investors.
Historically, students of finance have ignored the role of emotion in the investment world. Instead, they have focused on developing tools for investors to measure and control risk and optimize return. This endeavor has been fruitful, yielding ideas about diversifying investments and finding undervalued stocks. Although investors should use these tools for investment decision-making, they typically do not, because psychology and emotion affect their decisions more than financial theory does.
For example, our desire to feel good about ourselves causes us to sell stocks that have risen in price. Selling a winner makes us feel like we made a good decision buying that stock and makes us feel like winners too. However, we also want to avoid feeling the pain of regret. So we hold onto losing stocks too long. The consequences of these emotions are that we sell high-performing stocks and keep low-performing stocks. This behavior not only diminishes our future returns, it also causes us to pay higher taxes. That is no way to increase our wealth!
Overcoming our emotions in an attempt to make good investment decisions is not easy. We have trouble enough controlling ourselves in all aspects of our life, let alone our financial life. However, we seem to get more help shoring up our willpower in non-financial matters. For example, many books and articles show us how to overcome the roadblocks we put up for ourselves: problems with our relationships, sticking to our diet, continuing our exercise program, or living by our faith. By contrast, we get very little help managing our debt, our budget, or our investing.
Which is unfortunate, because making financial decisions is difficult to begin with. We must make decisions based on information that may be inadequate or inaccurate. And we must be able to effectively understand and analyze that information. The task becomes more difficult when we let our emotions get in the way of good decision-making.
Consider these common investment laments:
“If the stock’s price would just go back up to what I paid, I would sell it.”
“Why do I seem to buy high and sell low, instead of the other way around?”
“I knew I shouldn’t have bought that stock, but I did it anyway.”
“I know I should be contributing to my retirement plan, but I never seem to get started.”
If you have made comments like these, then you have let your investment decisions be affected by your emotions.
We are constantly bombarded by the media with opinions and ideas that others want us to have. Are these opinions and ideas, put forth by banks, brokerage firms, insurance firms, and the rest of the finance industry, really the best for us and our money?
In future articles, I hope to explore with you the other side of the coin of investing—to help you think about money and the world of finance in a different way.
John R. Nofsinger is professor of finance at Washington State University and author of the book Investment Madness. He can be reached at John_Nofsinger@wsu.edu.