The Emotional Investor- A White Paper on Emotional Biases in Investment Decision Making

Investing
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By  Patrick Maffett

Learn more about Patrick on NerdWallet’s Ask an Advisor

“Compound interest is the eighth wonder of the world.

He who understands it, earns it; he who doesn’t, pays it.” ? Albert Einstein

The single most important factor in investment returns is something that very few individual investors are even aware exists in their trading decisions: emotional biases.

As a professional money manager and investment advisor to individuals, corporations, pensions and trusts, I must mitigate these biases in my own decision-making and help clients to manage their own emotions. It is far and away the most challenging part of my chosen profession.

For a moment, forget the academic theory and institutional research across finance and economics. Forget the ever-changing 24-hour news cycle, capital market assumptions, standard deviations, correlation matrices, alphas, betas, deltas, gammas and thetas that dominate the waking hours for left-brained investment professionals like me. For now, let’s ignore portfolio management and security analysis (in a separate paper I will address how differences in the latter two constituents of investors returns have more to do with luck than skill amongst professional investment managers across modern global capital markets) and just focus on emotional biases.

You’ve probably heard some version of the following statement: Mutual fund managers rarely outperform their benchmarks. What you really need to hear is something like this: Individual investors almost always underperform their mutual funds. Take a second to reread that last sentence and let it sink in.

Recent research from Morningstar indicates individual investors underperformed their funds by 2.5% annualized in the 10-year period leading up to 2013. Data from 1990 to 2010 show the average individual investor underperforming their funds by a whopping 5% annualized. At this point, I should pause for effect. Remember that 2.5%-5% annualized really adds up fast (go to an online financial calculator for a refresher in the effects of compound interest).

Why is this the case? How could investors be underperforming the funds they are investing in by such large margins? Shouldn’t investors expect to “beat” the market or the funds that invest in it?

Let’s ignore the argument between active and passive investment management and focus on the topic at hand. The short answer can be summed up like this: Individual investors underperform the market and the funds they are invested in because they allow emotional biases to affect their investment decision-making. For the record, I’m not standing on a soapbox typing this paper. Seasoned professionals, expert amateurs, gray-haired hobbyists and rookies all are susceptible to emotional biases that can hurt your returns and chances of long-term investment success. The difference between the successful investor and the homeless former day-trader is the ability to recognize and control the effect of these biases.

Globalization and technology have made markets more liquid and trading much more of a real-time activity than any point in history. Now more than ever, the temptation to buy or sell at a moment’s notice can be acted upon with little effort and negligible transaction costs. Gone are the days of calling your broker to discuss a decision before the closing bell. Today’s investors need to be even more keenly aware of the emotional biases at play because they can act upon them so much more quickly (often to their detriment).

Before going on, I should reiterate that this is not an argument for passive management or a slander against active management. My day job tends to include implementing, to varying degrees, a combination of those approaches to investment management for many different clients with many different investment mandates.

To peel the onion back further, differentiate between two types of emotional biases: of fear and of greed. In a separate paper, I may go into greater detail on a number of these biases, but the following paragraphs should serve the purpose of this piece.

Fear-based biases are essentially emotional responses to the attachment we have to money. Studies indicate that monetary losses have twice the psychological effect as gains. People panic when the market is down because the genetic and evolutionary responses to losing money (and future security) are hard to reconcile with the volatile and unpredictable nature of markets. The trick for investors is not to monetize/trade on emotionally driven decisions. There are myriad ways to rein in these forces.

Greed-based biases are the other side of the coin. Just like going to Las Vegas and winning a few lucky hands, the lucky trader immediately begins to forget the long-term risk/reward tradeoffs in investing and starts to take unnecessarily risky positions. The origin of greed-based biases is equally hard-wired because we are free-willed, self-determining, rational consumers of scarce resources … aren’t we? Again, the trick for investors is to recognize and mitigate the emotional tendencies that are a natural part of our financial decision-making.

To put a bow on it, this lesson basically comes down to staying recognizing the importance of objectivity and acting accordingly. Take a long, hard, left-brained look at your finances today and where you want to be down the road, and figure out how to pursue the best investment strategy to meet those ends. If you don’t want to dedicate the time and effort to educating yourself, find a professional advisor you trust. Don’t go along with the prevailing herd mentality in the markets and let emotional decisions eat away at your investment returns and the long-term financial success of you and yours.