Financial Education | 11 January, 2018

How emotions affect investment decisions?

Raúl Rendon Portfolio Manager

Our emotions influence our decisions. It is vital therefore that we analyse how emotions impact investment decisions, and according to our investor advice and the favourable market indicators, we can reach success when investing.

Did any of the following recent news items catch your eye…? For example, Leonardo Da Vinci’s painting “Salvator Mundi” was sold for a record price of US$450 million. Midway through the year, Argentina placed 100-year bonds, despite having reported eight defaults in the last 200 years. Or what can we say about the price of the Bitcoin, which reached values close to US$20,000, while just a year ago it was priced at around US$750?

The foregoing examples are recent, but history is full of fantastic events that remind us that bubble periods are the norm rather than the exception. What can we say about Tulip mania? Or about the performance of the South Sea Company shares that plunged the very Sir Isaac Newton into ruin?

Why do people decide to buy certain assets?

Very briefly, based on its functions, the brain can be split into three parts:

  • The spinal cord and brain stem which are responsible for the most basic vital functions (breathing, blood pressure, etc.)
  • The limbic system, responsible for motivation, instinct, emotion, learning and memory
  • The cerebral cortex (neocortex) in charge of the rational brain.

So there we have the guilty party: The limbic system is the part of the brain responsible for motivation, instinct, emotion and memory, amongst others, this being the “emotional brain” which explains why investors move in groups, taking part in bubbles due to states of euphoria or selling their assets at a discount in corrective periods.

emotions - trade

Investors suffer the greatest harm when memory and emotion work hand in hand. Our readers will most certainly know of cases in which, after considerable monetary losses, an investor invests substantially less than they would do in other circumstances. Or, the opposite, cases where investors invest more than usual after a successful operation.

In the article written by Richard H. Thaler (Nobel prize for behavioural economics) and Eric J. Johnson (Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risk Choice) refer to how sentiments affect decisions and describe the house money effect that occurs when a person receives a higher than expected amount of money or goods.

The authors call it the “house money effect” because it is similar to how gamblers behave in casinos: It is usual that once betters have won some money, they are more willing to assume risks thinking that they are playing with house money, although it is actually their winnings not house money at all.

Extrapolating the foregoing to the financial markets, how many investors today are following this pattern? How many are actually basing their decisions on an understanding of an investment process philosophy and not just on past yields (Bitcoins) of some assets that open the doors of a limbic system anxious for quick thrills?

 

It is difficult to control sentiment when investing because precisely, as human beings, we are prone to following trends, unconsciously influenced by stories and mass trains of thought, making them our own.

The aim of this article is not to determine whether or not we are in an equity market (or any other asset) bubble, rather it is an invitation to reflect on how we take our decisions, above all bearing in mind that if history is anything to go by, at some time in the future, we could be tempted to take part in some “bubble”, following what the masses are doing.

Investors should undoubtedly put the analytical part of the their brain (the neocortex) to work and give their limbic system a break; an exceedingly complex situation that necessarily highlights the importance of having an investment advisor with a “cool head” close at hand to help us take the best decision possible.