Emotions Can Derail Investment Discipline

April 27, 2009

Individual investors must understand the importance of maintaining a disciplined investing strategy despite emotional responses to the market.

One of the most important things that individual investors need to understand is the importance of maintaining a disciplined investing strategy. For most investors, this discipline can be difficult to maintain because of the challenges of prevailing over emotion.

Various behavioral studies have documented the dominant role of emotion in investment decisions. The all-too-common result of too much emotion is, naturally, to reduce rationality. These studies have shown that the joy that investors experience from high returns tends to be far less intense than the pain they feel from losing money in the markets.

Fear prompts investors to sell when perhaps they shouldn’t—commonly, after a stock’s price has already plummeted. They flee the market when it drops, despite the emergence of opportunities to buy low. These tendencies make investors sell low and buy high.

Last fall’s market meltdown has been widely attributed to a reaction to the sudden constriction of liquidity in the credit markets following the collapse of major Wall Street institutions. While that was doubtless a factor, it was not the direct cause. Rather, the direct cause was rooted in individuals’ fears. Gregory Berns, a professor psychiatry and behavioral sciences at Emory University’s School of Medicine, offers a succinct explanation of how these individual fears collectively brought down the market: “Fear plus herding equals panic; it’s biologically based.”

Such stampedes to sell can come in reaction to long periods of irrational exuberance compelling investors to buy at higher and higher prices over time. As they purchase stocks at escalating prices in a bull market, they become accustomed to taking greater and greater risks. When the bubble bursts, fear sets in and suddenly makes investors risk-averse—so much so that they want to get all the pain over with as quickly as possible by selling indiscriminately.

Berns has documented the neurology underlying this phenomenon by showing how research subjects respond to the anticipation of pain. After giving the subjects an initial electric shock while in an MRI, he gave them a choice of either receiving an additional, intense shock immediately or a less intense shock later. Those subjects whose brain imaging indicated intense fear connected with the anticipation of further pain were far more likely to take the intense shock at the time rather than the lesser shock later. Thus, fear of future pain prompts investors to sell stock that has already gone off a cliff.

Investors’ irrationality not only causes them to make the wrong investment decisions, but also to make decisions for reasons that have nothing directly to do with investing. Michael Platt, a neurobiologist at Duke University’s Center for Neuroeconomic Studies, has done studies indicating that investors’ desire for money is linked with their desire for social status, indicating possible motivations for investing other than financial gain.

The linkage of successful investing with social status has been thrust on the public stage in recent months as we’ve witnessed the amazing fallout of the Bernard Madoff scandal. In an abandonment of due diligence, investors were pursing Madoff to gain admission to what turned out to be a gigantic Ponzi scheme. Unlike most portfolio managers, Madoff didn’t have to court investors—quite the contrary. You had to “know somebody” to be considered for access to Madoff’s firm. Becoming a Madoff client carried significant social status. Investors were willing to turn a blind eye to due diligence, in part because of the status of being able to say they were “in.” So $50 billion disappeared because of irrational, emotional motivation. Of course, there were individuals and institutions who wouldn’t invest with Madoff because he couldn’t supply documentation required by their rational due-diligence processes.

These investors didn’t let emotions derail their investment discipline. You shouldn’t either. Instead, try taking some time to carefully consider each investing move. Step back and examine your motivations for buying or selling, considering what you’re trying to accomplish. This way, you’ll be more inclined to act on reason instead of passion.

Andrew Samalin, an Accredited Investment Fiduciary (AIF), is president of Samalin Investment Counsel, a firm that offers financial advocacy services to individuals and businesses. The firm has offices in Westchester County, N.Y., and New York City.