Tuesday 10 March 2009

Using Emotions and Psychology to Investing Advantage

Emotions generally receive criticism when it comes to investing. People are constantly exhorted to banish their emotions - to be dispassionate at all times. Wrongo, pal! Just as in other areas of life, emotions can be good or bad.

Enter the idea of emotional intelligence (EI), which in similar fashion to intelligence quotient, is a measure of how "good" you are at emotions, how well you handle and harness them to advantage. More precisely, "Emotional intelligence is a person’s ability to recognize and interpret emotions and to use and integrate them productively for optimal reasoning and problem solving."

A new CFA Institute sponsored research study Emotional Intelligence and Investor Behavior by financial economist John Ameriks , and psychologists Tanya Wranik and Peter Salovey (free download here) studied several thousand investors from Vanguard to see the effect on investing behavior of EI, personality and impulsiveness.

Among the interesting findings:
  • being neurotic can be beneficial: neurotic investors avoided the error of holding too much equity (which they define as over 90% allocation) in their portfolio
  • using emotions to enhance thinking and problem solving caused people to shift their asset allocation out of stocks as did greater age, higher educational attainment and having an interest in math, finance and statistics; the authors judge portfolios with less than 50% allocation to stocks to be bad, calling it under-allocation, but that is debatable n'est-ce pas?
  • investors good at using and managing their emotions and whose personalities were less driven by urgency traded less frequently, a good thing
  • the split between investors who chose only index funds and those only in actively-managed funds showed some puzzling and seemingly inconsistent results - all types of people invest both ways!
  • although investors who were motivated by urgency achieved better returns (more urgency = high returns) the effect disappeared when adjusted for volatility/risk. The authors say, "... no single character trait dramatically increases or decreases IRRs." It depends on the situation and circumstances.
  • investors high in EI were "... somewhat more conservative and less aggressive in risk taking", less likely to trade often, more likely to use index funds but didn't achieve better returns!
  • "... being anxious can have positive as well as negative effects. If anxious individuals worry about their financial future, they may spend more time searching for information and choosing the best options."
  • "Impulsiveness is the only psychological construct [trait] that seems to have clearly negative relationships with the chosen financial indicators." Being impulsive - acting without thinking things over or feeling compelled by a sense of urgency - is bad for your investing health.

One very good suggestion of the authors is that companies should be careful in setting the default option for fund choice(s) in defined contribution pension plans. A lot of people are agreeable and they just go along with the default and may end up investing all their retirement savings in shares of the company they work for, a high risk situation - if the company ever has problems the value of the savings go down while the investor/employee may simultaneously face layoff. I think regulators should assert their power and dictate a very middle of the spectrum asset mix using low-cost index funds as the default to protect such people.

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