Investing with Emotion

August 29, 2018
Posted in Blog
August 29, 2018 Mduduzi Luthuli

Though many professionals — doctors as well as lawyers, architects and engineers — get to choose their specialisations, they rarely get to choose the problems they solve. Problems choose them. Investors enjoy the unique luxury of choosing problems that let them maximize the use of not just their IQ but also their EQ — emotional intelligence.

Let’s start with IQ. Our intellectual capacity to analyse problems will vary with the problem in front of us. Just as we breezed through some subjects in school and struggled with others, our ability to understand the current and future dynamics of various companies and industries will fluctuate as well. Therefore, we buy shares that fall within our sphere of competence. We tend to stick with ones where our IQ is the highest.

Though we usually think about our capacity to analyse problems as being dependable and stable over time, it isn’t. This is where our EQ comes in. No matter how rational or detached we’d like to think we are, the reality is that emotions often get the better of us. And when it comes to how we invest our money we must be particularly attuned to our feelings to sidestep emotional traps. We look at ingrained biases that affect us as investors and how we can look past our emotions.

When it comes to making complex investment decisions, many people follow a series of simple rules of thumb that in many cases are based on deeply ingrained biases that lead to irrational decisions. While these biases might be useful in helping individuals cope with day-to-day choices, they can be unhelpful for achieving success in long-term activities such as investing. By gaining insight into investor behaviour, investors can be coached to understand their own biases and make better investment decisions.

A practical example

Every month, when my wife and I contribute to each of our 2 daughters investment accounts, it gives me great joy. There’s something deeply satisfying to me that we have made this a commitment, that we have decided to trade off some immediate spending we could do to help our kids pay their way in future. Sure, it’s a financial decision that required logic to look over our needs and wants to find the money to make these investments. But the monthly decision to put money into their accounts is motivated by our love for our kids.

Logic plays an important role, but emotion drives us to make the monthly investment contributions to our kid’s inheritance fund.

On the other hand, our retirement investing seems much more logical. We know it makes sense to invest for our future, so we do. But why is this investing goal so unemotional? Is it because it’s a more distant goal? Is it because the monthly amount we contribute to our RA’s is automated? Is it because that phase of life is harder to envision than seeing our kids fully equipped to pursue the path they want? Those are all probably contributing factors.

Emotion plays an important role, but logic drives us to make our RA investments contributions.

So, what should I do?

Improving investing with emotional intelligence requires more than self-awareness.

One thing that investors can do, and I’d guess less than 1 percent do this, is to have a written plan before they make any investment. Having an exit plan on the way up and on the way down beforehand is a good way to minimise emotional involvement.

Sometimes it doesn’t matter how much complex quantitative analysis you perform on a share. At the end of the day, share price is determined by the market, not by a number that a supercomputer algorithm spits out. Financial markets are made up of millions of people around the world. Understanding how other investors are feeling, identifying why they are buying and selling and anticipating what they will be doing next all involves emotional intelligence.

Instead of succumbing to frustration, investors that have consistently struggled in the market should first try to take personal inventory of what types of behaviours seem to be driving the poor performance. Look for patterns of behaviour that might include impatience, impulsive decisions, stubbornness, anger, fear and indecisiveness. If these emotions are often part of your investing decision-making process, it may be time to work on improving your emotional intelligence.

Conclusion

Human decision making is an amazingly complex topic. I am not a licensed psychologist, but I have huge experience treating a very difficult patient: me. And what I have found is that emotions have two troublesome effects on me. First, they distort probabilities; so even if my intellectual capacity to analyse a problem is not impacted, my brain may be solving a distorted problem. Second, my IQ is not constant, and my ability to process information effectively declines under stress. I either lose the big picture or overlook important details. This dilemma is not unique to me; I’m sure it affects all of us to various degrees.

Emotionality has always been considered the opposite of rationality. But this presents a dilemma, because we know emphatically that emotion activates the brain. Whether the emotion is anger, euphoria or fear, it triggers neurotransmitter changes that kick the brain into a hyper-alert state. Clearly when it comes to making decisions, it is better to have the brain activated, rather than not. Thus, by this reasoning, emotion should aid decision making. It can’t do so though unless you have an investment process you have conviction in.