How Emotions Guide Your Investing And Why That's a Good Thing

Watch out classical economists, there's a new game in town. It's called "behavioral finance," and it might just take over the 21st century stock market.

Traditional economics pictures the investor as a detached moneymaker, a sort of Gordon Gecko meets Deep Blue with a dash of Mr. Spock thrown in on the side. It's called the "efficient market hypothesis," a world in which investors always act like perfectly rational beings based on public information.

Anyone who has watched the stock market over the past ten years, or who has ever met a living, breathing human being, can probably tell you just how this theory works in practice. It dominated economic thinking for decades, though, until not that long ago someone started thinking: what if human beings don't suddenly become automata when they enter the stock market? What if investors act, in fact, like people?

And thus behavioral finance was born.

This is the theory that investors, especially individuals, bring all of their emotions, assumptions, worries and priorities to the table when it comes to managing their own money (a trend that seems particularly borne out in the practice of "impact investing").

An increasing number of advisors have begun to adopt this theory. Today responding to the basket of emotions and personality that every investor brings to the table has become an important part of working with clients.

The first rule of thumb? It's O.K. to get a little emotional when it comes to your money.

"I think emotions are largely mischaracterized as something negative or something to resist," said Michael Liersch, the head of behavioral finance for Merrill Lynch. "You see this in the public domain all the time, and it's one of my pet peeves, that you should take emotions out of it and you should divorce yourself form the situation. All the research says that's just not possible."

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