The importance of emotions in the world of investment

Traditional theories of finance tend to see people as rational beings who try to maximize utility and have perfect information. But are we humans like that? The answer is not. Sometimes we humans are rational, but at other times we are guided by our emotions or look for shortcuts, given our inability to process all available information.

We do not seek to maximize utility and it is sufficient for us just to find a satisfactory answer to our problem. Neither do we make decisions using perfect information, but instead make them using the information we have to hand.

Many factors stop us from making rational decisions. Behavioral finance summarises them in two: biases and shortcuts. Biases are systematic errors that we make, which since they are predictable, meaning we can avoid doing them. Shortcuts occur when we are unable to process all available information and look for a quick way to do something.

For example, one of the most common biases is the overconfidence bias. If you were asked if you think you are an above-average driver, what would you say?

In a survey conducted in the United States, 93% of drivers considered themselves to be “better than average”. When logically that is not possible. This is due to the overconfidence we have in ourselves.

In the world of investment, we also have many biases that stop us from making rational decisions. In these cases, we are risking our money, so it is very important to be as rational as possible.

Advice when making investment decisions

It is important when investing to think carefully and has good arguments for buying or selling, and never to get carried away by excitement or fear. That is why it is important to be in professional hands and have a good long-term asset allocation strategy. This will ensure that all our investments fall within a previously analyzed plan. It is convenient to keep the bulk of our portfolio in long-term strategic ideas and thereby minimize opinion and unintended biases.

In short-term tactical investments, which tend to be more dependent on opinion, it is important to guard against unconscious biases. There are some tricks that we can use to avoid these biases.

Along with the overconfidence bias, another of the most common biases is the confirmation bias, through which we tend to look for information that supports our opinion and try to avoid any that goes against our view. If we write down all the bad things that could happen with an investment, we will have a clearer idea of how we should act in each situation and how much the ideal amount to invest would be.

Another of the most common biases is to keep investments in our portfolio which have not gone as well as expected and are making losses. A large number of studies have discovered that, in general, humans get around twice as much pain from a loss, as they do joy from obtaining a profit of the same size. This is known as loss aversion.

We are risk-averse with profits, but with losses, we are risk-prone. This often means that our fear of losing even more from an already loss-making investment leads us to risk more money and to keep the investment for a long time hoping it will recover. On the other hand, with profits, we want to make certain of them and sell quickly to cash in on our gains, when in most cases the best thing is to do precisely the opposite: maintain good investments for the long term and quickly get rid of our worst investments.

One of the tips for discovering if we should sell an investment that has gone wrong is to imagine that, while they are playing, a child presses the button to sell some shares. If this happened, would you buy the shares again? If the answer is no, you have to sell.

An investment we make is one that we would buy again every day because we continue to believe in it. An investment that we maintain only because it hurts us to take a loss on it, would not appear to be a good investment.

A small case study of investor behavior

Imagine that you have been offered 1,000 euros to give a presentation at a conference. When you get paid you are given the following options:

• The first one involves tossing a coin: if it lands heads up you will be paid 2,000 euros, but if it comes down as tails you get paid absolutely nothing.
• In the second option, you get paid 1,000 euros as agreed.

Which would you choose?

Now imagine that you arrive at a hotel where you are going to stay and the person at reception offers you two payment options:

• The first option is to toss a coin: If it lands heads up you pay 2,000 euros, but if it comes down tails you stay for free.
• The second option is to pay 1,000 euros for room costs.

Which would you prefer?

Human nature encourages us to choose the safe option when getting paid for the conference but to choose to toss the coin when paying for the hotel to try and get it for free. That is, with again (receiving payment) we want certainty, but with a loss (making a payment) we are prepared to increase the risk to try and get something for free (or not to lose anything).

It would be rational to choose the same option in both cases. In other words, either I risk-prone with my money or, on the contrary, I am risk-averse. In general, humans are risk-averse (considering risk to be real loss). And that is why the rational thing would be to always choose the option of certainty. Especially considering that one of our cognitive biases is loss aversion.