December 2001

Are You a Rational or
Emotional Investor?

© Talbot Stevens

Are you a rational or emotional investor? Do you make investment decisions with your head, or with your heart?

People like to think that they behave rationally and act as a result of logical analysis. The reality is that most of us make decisions emotionally, and then rationalize them with logic.

Understanding how and why we manage, or mismanage, money is important to becoming more financially successful. It is so important that a new field of psychology has emerged called behaviour finance, that is attempting to help us better understand why we spend and invest money the way we do.

An interesting book on the subject is "Why Smart People Make Big Money Mistakes", by Gary Belsky and Thomas Gilovich. One of the book's insights is that investors are much more motivated to avoid losses than they are by the potential for gain. This is an important lesson for investors during down markets.

As one example of the tug of war between the head and the heart and how difficult it is for someone to know what to do during down markets, consider the following.

What is the most rational time to invest in the market, when it is up 30% or down 30%? What is the scariest time to invest in the market, up 30% or down 30%? What is the safest time to invest, when the market is up or down significantly? Ironically, the answer to each of these questions is the same.

When the market is significantly down, it is simultaneously the most rational, safest, and yes, scariest time to invest more. After recognizing the multiple contradictions here, it is easy to understand why so many investors are paralyzed and often do the opposite of what their heads know they should do.

Generally, investor behaviour is so entrenched in us and is so consistently backwards from what we need to do, that one could almost be a successful investor simply by blindly doing the opposite of what the masses do.

We all know we should "buy low and sell high", but because we generally do not make financial decisions with our head and are more influenced by the emotional fear of losing money, we often end up buying high and selling low. But the key to financial success is not what you know, it's what you do with what you know.

When markets are down, the emotional response for the majority is to react out of fear, and wait until the market is up before getting back in. The successful minority does the opposite, and proactively takes advantage of the opportunity to buy low.

Which group are you currently in? More importantly, which group do you want to be in? Trust your instincts. Trust your "gut". It knows what you need to do and is almost never wrong.

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