Emotions-Based Investing

Obsessively playing the stock market is recognized by Gamblers Anonymous as a form of gambling addiction. San Francisco clinical psychologist Paul Good developed a set of warning signs that may reveal whether an active investor is actually a compulsive gambler in disguise. Among them are a preoccupation with the financial media, borrowing to speculate (leverage), inability to cease or control trading activity, and throwing good money after bad in order to break even1.

As the head of the Gambling Disorders Clinic at Columbia University, Dr. Carlos Blanco has a lot of experience with gambling addicts, and he says one difference between obsessive active investors and chronic gamblers is the age in which the disease is most prevalent. Pathological gamblers are typically in their late teens and early 20s while people who are addicted to speculating in the stock market are commonly in their 30s and 40s.

Behavioral finance is a field that studies the connection between investors' emotions and their financial decisions. In The Little Book of Behavioral Investing: How Not to be Your Own Worst Enemy,2 author James Montier talks about the importance of planning ahead to protect us from the "behavioral biases that drag down investment returns." He highlights the need for investors to pre-commit to an investment strategy in order to avoid the pitfalls of emotional decisions.

In Your Money & Your Brain,3 financial writer Jason Zweig details evidence of the release of addiction-related dopamine in our brains when we anticipate big wins. "The dopamine rush we get from long shots is why we play the lotto, invest in IPOs, keep too much money in too few stocks, and invest with active portfolio managers instead of index funds," Zweig states. "Our brains are wired to force us into forecasting; it is a biological imperative. In fact, humans are born with what I've come to call 'the prediction addiction.'" Several researchers working in neuroeconomics, including Harvard's Hans Breiter have identified a striking similarity between the brain's reaction to cocaine and the prediction of financial rewards4.

Even wealthy individuals struggle with emotions management and investing discipline. A recent Barclay's study5 found that 41% of high net worth investors wished they had more self-control over their investing decisions. The study concluded that emotional trading can cost an investor about 20% in returns over the 10-year period studied. Investors who prevented themselves from over-trading through specific strategies were, on average, 12% wealthier than those who did not use self-control mechanisms. These self-control strategies include minimizing time spent checking their portfolios or seeking advice prior to making a buy or sell decision.

Several behavioral biases that affect decisions may include:

  • Overconfidence: People mistakenly believe they can outperform the market.
  • Hindsight bias: Investors think past events were predictable and obvious and believe they should have known better, when in truth, news is what moves the markets, and past events could not have been predicted in advance.
  • Familiarity bias: Investors invest only in stocks they know, which provides a false sense of security. An example may be a "legacy" stock that's been passed down in a family through generations. Geographical bias also comes into play when investors choose stocks of companies headquartered in their state or region of residence, which can lead to undiversified investments.
  • Regret avoidance: Investors vow to never repeat the same decision if it resulted in a previous loss or missed gain, not accepting that the future cannot be predicted.
  • Self attribution bias: Investors tend to take full credit for investment gains and blame outside factors for losses, wrongly attributing success to personal skill instead of luck.
  • Extrapolation: Investors base decisions on market movements, assuming the perceived trend will repeat.

These behavioral biases cause investors to believe they have control in areas where they actually have little or none. A disciplined, rules-based investing approach involves the understanding of the factors we can and cannot control, planning ahead and not giving into emotions when making investment decisions.

Figure 1-2 depicts the roller coaster of emotions active investors experience. In the emotional cycle, they wait until they feel confident their selected investments are on a perceived upward trend; then they place their orders. But once prices have fallen, doubt sets in. When that doubt turns to fear, they often sell the investment, resulting in a loss.

Figure 1-2

In contrast, Figure 1-3 shows the relaxed emotions that indexers enjoy by accepting market randomness and relying on investing science instead of making decisions based on emotions. Passive investors invest regardless of market conditions, because they understand that short-term volatility is unpredictable. They know that succumbing to gut instincts and emotions undermines long-term wealth accumulation. They also know that news about capitalism is positive on average — but involves some stomach-churning volatility.

Figure 1-3

In order to regulate their risk, passive investors also engage in periodic rebalancing and are rewarded in the long term for their discipline. Figure 1-4 depicts the disciplined emotions and approach of "Rebalancers" who sell a portion of their funds that have grown beyond their target allocation and buy more of other funds to restore their target allocation. This is actually the opposite behavior of active investors, because rebalancers will sell a portion of their portfolio after it has gone up and buy more of those investments that have declined in order to maintain a specific asset allocation. This strategy seems counterintuitive and can be emotionally difficult to implement. Rebalancing requires discipline and ensures that a portfolio will remain at a relatively constant level of risk.

Figure 1-4

The impact of emotional triggers on investor performance is a subject of much analysis. An annual study called the Quantitative Analysis of Investor Behavior (QAIB),6 which has been conducted by Dalbar since 1994, attempts to measure the impact of investor decisions to buy, sell and switch into and out of mutual funds. Each year, the study has shown the average mutual fund investor earns significantly less than the actual mutual funds over the same time period. In fact, the report issued in April 2013 opened with this headline: "The Disease of Investor Underperformance."

Dalbar's 2014 QAIB study succinctly states, "No matter what the state of the mutual fund industry, boom or bust: Investment results are more dependent on investor behavior than on fund performance."

The Dalbar study further addresses the problems with performance chasing investor behavior by stating, "Mutual fund investors who hold on to their investments have been more successful than those who try to time the market." The report has shown for the 20th time in as many years, that "the average investor earns less — in many cases, much less — than mutual fund performance reports would suggest."

Figure 1-5 illustrates the results of the 2015 Dalbar study, which includes a comparison of the returns of an average equity fund investor to the returns of the market from 1986 through 2015. Permitting their decisions to be driven by short-term volatility, the average equity fund investor earned returns of only 3.69%, while a buy-and-hold investment in the S&P 500 returned 10.35%. An investment of $100,000 made in 1986 grew to $293,992 over the 30-year period for an average equity fund investor, while the same amount invested in the S&P 500 grew to $1,919,420. Even better, an investor who owned an all-equity, small value tilted, globally diversified index portfolio would have grown a $100,000 investment to $2,289,230. Clearly, investor behavior can have a far more negative impact on investments than investors realize.

Figure 1-5

    -1 Ted Knutson, "When Investing Becomes a Gambling Disease," Financial Advisor, March 3, 2014, http://www.fa-mag.com/news/when-investing-becomes-a-gambling-disease-17052.html
    -2 James Montier, The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy (Hoboken: John Wiley & Sons, Inc., 2010).
    -3 Jason Zweig, Your Money and Your Brain (NY: Simon & Schuster, 2007).
    -4 Jason Zweig, "Brain Tour: It’s a pleasure," CNN Money, September 27, 2002, http://money.cnn.com/2002/09/16/pf/investing/agenda_brain5/
    -5 Dr. Ian Ayres, Dr. Peter Ayton, Dr. Greg B. Davies, Dr. Barbara Fasolo, Professor Thorsten Hens, Sheena Iyenger, Dr. Annie Koh, Dr. Neil Stewart, Rory Sutherland, and Dr. Chun Xia, "Risk and Rules: The Role of Control in Financial Decision Making," Barclays Wealth Insights, vol. 13 (2011).
    -6 Dalbar, Inc., "2014 Quantitative Analysis of Investor Behavior," (2014).
Step 1Jason ZweigDalbar