Dr. Meir Statman is a professor of finance (with a focus on behavioral finance) at Santa Clara University. You might say he is a foremost expert on how emotions can affect financial decision-making for managers and investors. His most recent book, “Finance for Normal People: How Investors and Markets Behave,” is pretty much a dead giveaway for where his life’s work is focused.
So, when Dr. Statman pens an article in the Wall St. Journal titled, “How Emotions Get in the Way of Smart Investing,” it is probably worth a close look. Indeed, the relationship between human emotions and investing is a complicated one – and it’s one that many experts would agree is at odds. Few would disagree with this general idea: investors who can remove emotion from the investing equation have a better chance of doing well over time versus those who cannot. As Warren Buffet succinctly puts it, “it’s an easy game if you can control your emotions.”
Investing, of course, is no game. But what Dr. Statman and Warren Buffet seem to be referring to is a fundamental tenet of investing. That is, the longer a person can stay invested in the market, and the more he/she can effectively ‘stay out of their own way’ with regards to emotional decision-making, the better the results are likely to be over time.
The problem with most people, however, is that emotion starts to creep-in at just the wrong times. As Dr. Statman puts it, “we should not kick ourselves with regret every time stock prices go down, and we should not stroke ourselves with pride every time they go up.” Most investors have been there before: getting a little too excited and willing to take risk as the market does well, and perhaps getting a bit too nervous or fearful as the market declines. Dr. Statman is implying something that most investors already know: the key is to recognize emotions when they start to influence changes to a strategy, and to exercise caution in these situations. There is a distinct possibility those emotions can get us into trouble.
Thinking about investment psychology and the relationship between emotions and investment decisions brings to mind the following chart from J.P. Morgan Research. It’s a familiar chart for many readers, showing the impact of missing only a few of the best days in the market. The chart illustrates that, historically, the investor who remains invested throughout the good and the bad has ended up with better performance (and therefore more money) than the investor who found themselves on the sidelines during a few, or many, of the best days in the market.
Of particular note in this chart – and a feature that is often overlooked - is that six of the ten best days occurred within two weeks of the ten worst days. In other words, the best and the worst days are very often close on the calendar to each other. This fact is an important one, because it is oftentimes the worst days that cause investors to sell out of stocks in the first place, in a knee-jerk emotional response to declines. But it’s this emotional response that can prevent the investor from participating in the best days needed to generate the highest return.
One Method for Controlling Emotion: Hiring an Advisor
A financial advisor should be a lot of things for an investor: a good listener, an investment guru, someone who can help you plan for retirement and the needs of your family. But a financial advisor should also be there to help investors recognize when emotion is the thing driving an investment decision, especially if that decision runs counter to the long-term goals the investment plan is designed to fulfill. In other words, a financial advisor should often help an investor ‘stay out of their own way.’