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As I worked toward my undergraduate degree in finance, then my Certified Financial Planner® designation and finally my master’s in financial planning, I was consistently taught about “rational choice theory” and its place in modern portfolio theory. I learned that rational investors always make the right decisions based on facts and statistics, not on emotions or gut reactions, and that’s why markets are so efficient over the long term.
In the sterile world of academia, it’s easy to know the right thing to do: Buy when prices are low, sell when prices are high, and stay invested for the long run. Securities should be bought or sold based on their fundamentals, not a neighbor’s advice or an impulse driven by fear or excitement.
Armed with these theories, reinforced over many years of study, I set off to become a financial advisor — to help people reach their financial goals through rational and unemotional planning and investing. I truly believed it was basically just a numbers game.
However, once I started working with real flesh-and-blood people (not hypothetical “rational people”), it quickly became apparent that there are very few, if any, purely rational investors (or financial advisors, for that matter). If you stop and think about the people in your life, I’m quite sure you’ll agree that humans tend to lead with their hearts and guts, not their rational minds. It’s one of the most endearing qualities of being human. We all thought the cold, calculating, ‘logical’ side of the half-human, half-Vulcan Mr. Spock was cool — but we loved him because of the irrational, emotional, human side.
A full-blooded Vulcan would make an excellent investor and would surely adhere to rational choice theory. For us humans, our impetuous, impulsive nature, which tends to make us so interesting, also results in our having inherently bad investing instincts.
I was out walking recently, when a thought occurred to me that I think outlines the idea. Say you’re on a hike, and you come across a large bear. The rational thing to do, according to most experts, is to either lie down and play dead or stand as tall as you can and try to impress the bear with your size and ferocity. Having read your trusty wilderness guide, if you were to adhere to the laws of rational choice theory, you would choose one of these tactics, perhaps depending on the type of bear you’re facing and how the bear seems to be acting.
That sounds good on paper, but in real life, it would be very hard (if not impossible) for most people to do. In reality, if confronted with this situation, most of us would do exactly the “wrong” (or irrational) thing, which is to run for our lives. The fight-or-flight mechanism in our brains that makes us feel the need to ‘do something’ in the face of a threat can have highly detrimental effects in certain situations. When it comes to long-term success as an investor, it can be calamitous.
What I have learned in the years since leaving school is that to be a great advisor, and to truly help your clients stay on track toward their goals, you need to be good with numbers and statistics and analytics, yes — but more important, you must be good at recognizing and understanding the behavioral traps that lead investors to make bad decisions. Understanding how and why clients react to adversity and euphoria, and using this insight to guide them toward the right (or rational) decisions, is paramount in helping them achieve long-term success.
There is some good news. Although we cannot reprogram our brains or behavioral instincts in a single lifetime (or even, in fact, over many generations), there are some steps we can take to mitigate the instincts that tend to make us poor investors.
First, we can understand and accept our human side and the behavioral traits that cause us to make emotional or irrational decisions. If we know we are likely to act irrationally, and if we are able to step back and see our behavior for what it is — an impulsive reaction to stress or exuberance — we are much more likely to be able to resist.
A second way to keep emotion out of the equation — and probably the most important — is to have a plan and stick with it. This is why a written financial plan is so important and powerful. By planning for the future, and committing to paper what we will do in any given scenario going forward, we help eliminate the dreaded “F” word of finance and investing. That “F” word, of course, is “Feel.” As soon as we “feel” we must do something in the face of turbulence, we know that emotion, not reason, is running the show, and that creates a climate ripe for investing missteps.
As odd as it may sound, the key to solid long-term investing is never to “feel” — or, more precisely, never to respond based on what we “feel.” So much time and energy in our business is spent debating what investment strategy is best, even though there are any number of approaches that can result in positive outcomes. What’s most important is that we have a strategy and we stick to it.
A good financial plan or investment plan should be considered and articulated in a time of calm, so that it may act as a beacon when emotions are running high. If we can stay focused — not on the short-term noise constantly surrounding us, but on the long-term goals we have set for ourselves — we greatly increase our chances of financial success. The key for us humans (and even half-humans) is to have a plan, and stay tethered to it, particularly when our instincts are telling us to run.
Image via iStock.
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