Strictly Business: How Emotions Screw Up Your Investments

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Why do many competent, smart people make mistakes with their investments? It turns out that their feelings have been hurt, or they’re trying to save face, or they’re cocky enough to think they’re faster and smarter than the masses. Basically, they get emotional.

The world of investing is no place for feelings. The trick, according to a Santa Clara University professor writing for the WSJ, is to channel your inner robot—to simply stop behaving emotionally:

Most investors are intelligent people, neither irrational nor insane. But behavioral finance tells us we are also normal, with brains that are often full and emotions that are often overflowing. And that means we are normal smart at times, and normal stupid at others.

The trick, therefore, is to learn to increase our ratio of smart behavior to stupid. And since we cannot (thank goodness) turn ourselves into computer-like people, we need to find tools to help us act smart even when our thinking and feelings tempt us to be stupid.

Example: A guys owns shares of a stock that takes a nose dive. What does he do? He hopelessly holds on to it. He doesn’t sell, because by selling he’d realize the loss—and that would hurt. And what happens? The stock drops further, until it’s worthless, and the guy loses even more. The smarter move would be to bite the bullet and sell earlier, even at a large (but quite as large as it could be) loss.

The WSJ piece offers eight sensible lessons on becoming a Zen, unemotional investor, including:

The most obvious lesson is that individual investors should never enter a race against faster runners by trading frequently on every little bit of news (or rumors).

Instead, simply buy and hold a diversified portfolio. Banal? Yes. Obvious? Yes. Typically followed? Sadly, no. Too often cognitive errors and emotions get in our way.

Also, ignore the chattering masses:

When I hear in my mind’s ear a voice that says that the stock market is sure to zoom or plunge, I activate my “noise-canceling” device rather than go online and trade. You might wish to install this device in your mind as well.

While I heartily agree with the story’s advice, I worry that even if you are prudent about investing, and you do not allow emotions to get the best of you, the average investor is still at risk. Pretty great risk. A NY Times editorial laments the state of most 401(k) accounts, which often do not contain less money than their owners think—and it’s often not enough to retire on comfortably.

To help your own cause, in addition to avoiding emotion when investing, it’s smart to avoid emotion when making purchases too. You may feel like you need a donut, that you deserve a fancy car or a wall-size TV.

Splurging appears fun compared to taking a disciplined, robotic approach to consumption. And let’s face it: It is fun to own nice things. But ultimately, “stuff” isn’t going to make you happy. And buying all that stuff sure isn’t going to help your cause if you ever want to retire.