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."

The key to behavioral investing, according to Liersch, is recognizing that people "are not robotic."

"Future emotions actually play a role in the types of decisions you should make," he said. "There's this notion that if I get too scientific in these decisions that I'm making, in the future I may actually have made the right objective decision but subjectively I may not actually feel that great about it."

Critically, buyer's remorse can set in whether or not the decision was objectively good.

Understanding why it works that way requires taking a step back and remembering that, for an individual, money has a life far beyond the spreadsheet. It's about retirement, a new home, college educations and all of the years of work it took to build that careful nest egg.

Entering the wild world of the stock market means taking a risk with all of that and planning for the future it will bring. In a sense, it would be weird if that weren't an emotional moment.

Responding to those emotions takes an enormous amount of communication, starting with figuring out why the individual has invested her money in the first place. Goals, you see, matter. They matter to how one structures a portfolio, and they matter to how investors feel about it in the long run.

Someone who wants to save up for a major purchase, say a house, will behave very differently from future retirees. Others don't want their life savings to subsidize industries they find distasteful. Some parents begin their estate planning worried about how much money they should leave for their children, and a surprising number consider whether their will might do more harm than good.

A strategy that doesn't fit the investor's values and goals can leave them uncomfortable in the long run. They might do better on paper, but they won't feel good about it.

And that can even be bad for the bottom line.

"What you can think of as advice is taking in these emotional or preference based factors with the objective facts," Liersch said. "Let's say you have an investor who says that they really want to invest for the long run… but they also tell you that any time the market gets slow they want to sell, or they have sold. So how does one give the best advice to truly get the client where they want to go based on those options?"

It would be easy, he said, to try and force through a maximization strategy based around the numbers, but this is a client who might get skittish. If you don't take their concerns and priorities to heart when building a portfolio, they might spook during a recession and bail out entirely.

In the long run they'd be worse off than if you'd never worked together at all.

So instead, behavioral finance advisors try and find the middle ground, creating a strategy that listens to the client and builds that emotional need into the investments. Ultimately the individual feels better about having a portfolio that reflects them, and their money is safer than it might have been.

"Whatever the emotional outcome that is ideal, let's define that goal," Liersch said. "And maybe it will keep the investor invested because in the real world, not the hypothetical world, it will keep them in for the long run."

Of course, it isn't always that easy…

One major problem with behavioral finance is that it forces financial advisors to play a role somewhere between banker and therapist. They need to make sure they've completely understood the client's needs and heard from everyone who will matter in the conversation. An advisor who gets it right can craft a portfolio to suit her client, but one who guesses and gets it wrong… well, they can come across as arrogant or worse.

And sometimes, what a client really needs is to lean on their advisor's confidence.

Teasing all of that apart is one of the most difficult parts of behavioral finance, and it puts a major share of the burden on the investor. As a result, good advisors come with a secret weapon: a double dose of the usual paperwork.

The best advisors lay it all out on paper: what they would advise in a vacuum, what client-specific needs they identified and how their advice will serve. This doesn't just create a record that protects the advisor (although it does that too), but it allows the investor to review and decide based on clearly articulated information.

It is a critical step in the process; investors should beware of an advisor who skimps on the paperwork in any transaction but especially in behavioral finance, because ultimately this is a highly judgment-based field.

It is, however, a valuable one. Banks from Credit Suisse to Liersch's own Merrill Lynch have begun adopting the idea that emotions guide investment, and even some professors from the notoriously stodgy University of Chicago have begun to consider that maybe not everyone behaves like an Econ 101 hypothesis.

Although new, this is a field of finance that has enormous potential, not just to understand why people make the decisions they do, but to help them make better ones over time.

"When you just think about money," Liersch said, "it's all psychologically based. To really be authentic about it, the whole premise of money is emotionally based in essence. Removing emotion from investment decision-making is just a false premise to begin with."

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