Financial Decision-Making: A Slap in the Face

Intelligent reflection can help an investor make better financial decisions in the future and avoid the costly mistakes of the past.

During the 2008 financial crisis I entered the falling market with roughly a tenth of our reserves. At the time, the Dow Industrial Average was down 30%, instead of the roughly 40% where it later landed.

Though, I am not given naturally to discomfort when stocks drop in price, I began to feel distress as the general market fell further. Of course, I know it always reverts to the mean, but I didn’t know when this was going to happen. Would it be a year, 5 years, more? If it were going to be longer, I didn’t want to see 10% of our money diminish further. The Great Depression lasted from 1929 until WWII. Could this be another 10-year, 20-year, or longer drop?

As the days went by, the weight of my emotional burden (due to the descending value of the recently purchased stock) was too heavy for me to carry. To make myself feel better, I sold the purchases—or, at least, most of them.

One lot went unnoticed and accidently wasn’t sold.

When I see how it ultimately rose in value (as did the general market), it is like a slap in the face every time I open our account; I could make myself sick if I thought about it too much. Instead, I am trying to “train my brain” to act differently in case this scenario should happen again.

This revisionist approach to investing behavior is the latest in the bag of tricks that shareholders can employ to outperform the market. It basically involves acting with deliberation rather than automatically. It means using the prefrontal cortex to inhibit inherent reflex responses.

Analyzing my own actions, I believe particular personality traits had something to do with my miscalculation. My wish to take a risk to outperform the market was likely related to an openness to experience. This characteristic refers to individuals who are willing to look outward. In the market, this investor typically is someone who thinks taking a risk will yield more than a sure bet.

Though the wager I took seemed logical to me at the time, it didn’t work because I couldn’t sustain my emotional fortitude as the market fell further. One reason might be that I was less tolerant of taking risk that I thought. This could be attributed to another personality trait: extraversion. Those who score high on this characteristic tend to be risk takers. Another possibility is that the risk I chose to take was simply too great for me. If I had invested 2% instead of 10%, I might have held tight.

So, in the future, I am using this awareness to alter my investor behavior. I am “training my brain.” I know I should make small bets in a falling market instead of large ones. Or, I should wait for the market to begin to recover before taking on new positions.

Lucia Fung and Robert B. Durand gave us an update on this kind of logic in their chapter, “Personality Traits,” in the book Investor Behavior, edited by H Kent Baker and Victor Ricciardi (Wiley, 2014). In their chapter, these authors covered the 5 most important personality traits that influence investing behavior. They are included below and can be of help for those that are interested in further information regarding how personality influences financial decision-making.

Extraversion

Relating to social activity, a need for stimulation and even a capacity for happiness, this characteristic is associated with the brain dopamine pathway related to pleasure and reward. Since risk taking fuels release of dopamine, extraversion is associated with risk taking. Testosterone is also known to stimulate risk taking.

Agreeableness

Most would consider agreeableness positive and people who possess this trait are cooperative, trusting and pleasant. They are likely to show changes in the brain consistent with empathy to another person when studied with functional magnetic resonance imaging.

Conscientiousness

With the ability to carry out plans while delaying gratification, conscientiousness is associated with the brain chemical serotonin that is implicated in control.

Neuroticism

An indicator of emotional instability, those high in this trait are given to psychological distress including depression and anxiety. They may take risks to avoid a loss, possibility because of fear. These individuals generally do not seek risk to gain a reward.

Openness to Experience

As mentioned above, this characteristic refers to people who seek experiences for their own sake. Interestingly enough, it is associated with higher intelligence. Studies demonstrate that risk taking occurs in an individuals that score high on this trait when she thinks she can make a better profit by taking a risk than a sure bet would yield.

For Further Reading:

Are You a Born Financial Risk-Taker?

Why the Bull Beats the Bear

Scared Stockless: What Investors Need to Consider