Emotional Money and Investing

- February, 2003

Until the late 1970's when Daniel Kahneman and his research partner Amos Tversky first published a paper that set the foundation for behavioral economics, economists and investors minimized the emotional side of money. Since then, a body of research and practice has grown around the behavioral influences on investing and money management.

Simply put, we have begun to understand, and factor in, the idea that despite computer programs and proprietary investment technology, human beings still make, and break markets. As applied to almost any financial vehicle; the stock market, a startup venture, art investing, etc. value is created or lost by the aggregate decisions of individual human beings. The foundational work of Kahneman and Tversky, has fundamentally assured us that people have a consistent tendency to make financial decisions on the basis of emotion. Emotions are stronger than reason.

 The two emotions that have the greatest impact on financial decisions are greed and fear. Motivated by fear or greed or both, investors often invest or divest far above or below a company's intrinsic value. The result is clear that investor sentiment has far more impact on stock price or value than a company's fundamentals.

 You can look into almost any venture or commodity and see the same effect. In the automotive industry this year alone, new models from BMW, Hummer, Porsche and Acura all are selling far above suggested retail because of buyer "frenzy". In the art world where the intrinsic value of a master's work cannot fundamentally be counted, emotion drives the ultimate purchase price. And perhaps, the most obvious example of late, the burst of the dot-com bubble is a phenomenon that demonstrates the darker influence of emotional investing.

 These examples reinforce the notion that anyone who hopes to participate profitably in the market, must not fail to account for the impact of emotion. On the one hand you must account for your own emotional profile and on the other, account for that of the other investors whose emotional decisions present you with a compelling opportunity.

Before Kahneman and Tversky published their landmark paper, Benjamin Graham, the investment giant, tutored his students on the temperament of a true investor. He highlighted three key traits that are as true today as when he first described them.

1. True investors are calm. They know prices rise and fall. As long as the company retains the qualities that encouraged the investment, the value will go back up. On the other side, a true investor is not affected by the "mob influence." When everyone is making the same choices, no one is in a position to profit. True investors don't worry about missing the party. They worry about coming to the party unprepared.
2. True investors are patient. They say no, more often than yes. They avoid being swept into the enthusiasm of the crowd. The ability to say no is a tremendous advantage for an investor. One great perspective is to evaluate every opportunity as if you have only 20 investment decisions to make your entire life. If an investor's emotions were restrained in this way, they would be forced to wait patiently until a great investment opportunity surfaced.
3. True investors are rational. Neither unduly optimistic, nor unduly pessimistic, an investor uses rational and logical thinking to determine investment strategy. The emotional investor typically feels optimistic when the market is rising and pessimistic when the market is in decline. Often this causes them to sell at lower prices and buy at higher pric...not a great strategy to make a profit. The true investor realizes that while irrational optimism creates unduly high prices, irrational pessimism creates bargains.

By qualifying and gauging the tenor of greed, fear and desire as influences of significant investments, a true investor sees more accurately the value of an investment. In other words, as Warren Buffet has said, the true investor, "attempts to be greedy when others are fearful, and fearful when others are greedy."