How Your Emotions Get in the Way of Smart Investing

Ask investors what they want from their investments, and most will say the answer is obvious: They want profits.

Their answer may be obvious, but it probably isn’t true.

Inside all of us are wants we don’t always express or often even are aware of. When we make decisions about our money, we are often looking to satisfy those hidden emotional desires instead of doing what we say we’re doing—seeking out the best return possible.

But not being aware of these hidden wants can lead us to make potentially devastating errors that can hurt us both emotionally and financially.

For instance, we may trade stocks constantly—and lose money in the process—because it feels fun, more like a game than sober financial planning. On the other hand, we may refuse to take sensible risks to get a better return because we fear ending up poor. Or we may avoid selling stocks that have plummeted in value because we want to keep alive the hope that they will rebound, and we don’t want to admit defeat.

It’s important, therefore, to recognize and acknowledge our hidden desires. Doing so can help us make better choices and ultimately achieve the goals we really need.

So, what are we really looking for? There are three kinds of benefits—utilitarian, expressive and emotional—that we want from all products and services, including financial ones.

Utilitarian benefits are the answer to the question, “What does it do for me and my pocketbook?” The utilitarian benefits of a car are in ferrying us from one place to another, and the utilitarian benefits of investments are in increasing our wealth.

Expressive benefits convey to us and to others our values, tastes and status. They answer the question, “What does it say about me to others and to me?” A Prius hybrid, like a green-focused mutual fund, expresses environmental responsibility, whereas a stately Bentley, like a hedge fund, expresses high social status. Likewise, diamonds are largely devoid of utilitarian benefits but, among other things, help prospective grooms express their desirability as mates.

Emotional benefits are the answer to the question, “How does it make me feel?” A Prius and socially responsible mutual funds make us feel virtuous, whereas a Bentley and hedge funds make us feel proud.

To be sure, there is nothing necessarily wrong with making decisions for expressive and emotional reasons. The key is to be aware of them and to acknowledge that they carry a price—very often, a substantial one—in the form of higher costs or lower returns. We can increase the sum of our benefits if we understand our wants, weigh the trade-offs between them and choose wisely.

Here is a look at some of the things we want, and how to understand the hidden desires behind them.

Some of this stems from a classic error of overconfidence. Many assume that playing the market is like playing tennis against a practice wall—when in fact there is an opponent on the other side of the net, in the form of CEOs who move the market by touting stocks and professional investors who take advantage of those swings. Some amateurs recognize that there are pros playing against them but still think they can win. A survey of amateur traders reveals that 62% expected to beat the market during the following 12 months.

Yet we know from many studies that returns of heavy traders, on average, lag behind the returns of light traders, and the returns of light traders, on average, lag behind the returns of those who buy, hold and rarely trade.

Why do people keep doing it? Trading, like tennis, delivers expressive and emotional benefits. It is fun to play against Novak Djokovic, even if we lose. In one survey, for instance, Dutch investors showed that they cared about the expressive and emotional benefits of investing more than its utilitarian benefits. They tended to agree with the statement “I invest because I like to analyze problems, look for new constructions, and learn” and the statement “I invest because it is a nice free-time activity” more than they did with “I invest because I want to safeguard my retirement.”

Similarly, a survey showed that German investors who find investing enjoyable trade twice as much as other investors. And a quarter of American investors bought stocks as a hobby or because it is something they enjoy.

The lesson? Don’t kid yourself into thinking—as the studies show—that you can both beat the market (the utilitarian benefits) and get the emotional benefits. The game is more likely to reduce your profits and their utilitarian benefits than add to them. Make sure that you allocate no more than play money to the game, a small amount whose loss wouldn’t crash important goals such as retirement income, education and homeownership.

Rational investors follow the maxim, “Cut your losses and let your profits run.” I, and fellow professors of finance, teach students to recognize the tax benefits of realizing losses and overcome the reluctance to realize them.

So why do so many investors do the opposite, sell winners too early and ride losers too long? The answer is largely in our desire for the emotional benefits of pride and avoidance of the emotional costs of regret.

Buying a stock marks a hopeful beginning. We place the stock into a mental account, record its $100 purchase price and hope to close the account at a gain, perhaps selling the stock at $150. As fate has it, the stock’s price plummets to $40 during the following month rather than increase to $150. This is only a paper loss, we console ourselves. The stock’s price will surely recover very soon and climb higher. The mental account containing the stock is still open, keeping alive the hope that losses will turn into gains.

We need not acknowledge our paper losses fully before we realize them, but we face them and they gnaw at us. We feel stupid. Hindsight errors mislead us into thinking that what is clear in hindsight was equally clear in foresight. We bought the stock at $100 because, in foresight, it seemed destined to go to $150. But now, in hindsight, we remember all the warning signs displayed in plain sight on the day we bought our stock. Interest rates were about to increase. The CEO was about to resign. A competitor was ready to introduce a better product.

[“source-wsj.com”]