Taking the Emotions Out of Investing


Whether emotions are good or bad depends on the person and the situation, with one exception: money

By Charlie Epstein, CLU, ChFC, AIF®

Mr. Epstein, CLU, ChFC, AIF® is the founder of The 401k Coach® Program, which offers training for financial professionals to develop the skills, systems and processes in the 401(k) industry and facilitate successful retirement outcomes for plan sponsors and participants. He is the author of the book, Paychecks for Life®. He is a member of the Legg Mason Retirement Advisory Council.

 
Emotions can be heated. Emotions can run cool. Emotions can energize people to overcome seemingly impossible challenges, and they can cause them to collapse under intense pressure. Emotions can be an asset or they can be a liability. But one thing is for sure: emotions are always there.
Whether emotions are good or bad depends on the person and the situation, with one exception: money. It’s a widely held principle among professional investment advisors that emotions provide no benefit when it comes to investing. Investments are driven by fear and greed, and these two emotions don’t mix. Emotions make people falsely attached to their high-performing funds and tell them to stay away from low-performing funds. They cause false hope. They ignore danger. To put it bluntly, they cause people to do financially stupid stuff.
Let’s look at just a few emotions that, left unchecked, will greatly threaten the success of a 401(k) providing a Paycheck for Life® or enough money to live out the plan participant’s retirement years.

Overconfidence

Studies have shown that when people are asked to rate their level of expertise in a variety of areas, including finance, the majority rate themselves above average—a mathematical impossibility. Overconfidence makes investors believe that the success they achieve is due solely to their decisions and that they have the ability to do it again. That’s a mistaken belief, and one that’s difficult for investors to let go of.

Availability Bias

Investors can also project their outlooks too far into the future and let that bias their decision making. A classic example of this occurred in December 1996 when Federal Reserve Chairman Alan Greenspan made a speech to the American Enterprise Institute for Public Policy, where he coined the phrase “irrational exuberance” as a warning that stock market prices were inflated according to fundamental valuations. Few investors listened. They were convinced the market would march higher. After a brief fall, the market continued to climb higher and higher, thus prompting Greenspan to consider that, perhaps, prices weren’t inflated at all. In September 1998 at the Haas Annual Business Faculty Research Dialogue at the University of California, Greenspan said:
Some of those who advocate a “new economy” attribute it generally to technological innovations and breakthroughs in globalization that raise productivity and proffer new capacity on demand and that have, accordingly, removed pricing power from the world’s producers on a more lasting basis.
But the more prophetic words from Greenspan came moments later: “There is one important caveat to the notion that we live in a new economy, and that’s human psychology.”
People were convinced the market would do nothing but continue to climb. And it did—until human psychology took over. From 2000 to 2003, the market shed about 35 percent of its value, leaving investor accounts in shambles. But from 2003 until the end of 2007, the market gained 86 percent. Think of the consequences if investors were under-diversified when the market was losing 35 percent because they firmly believed it would continue to grow in the new economy. To make matters worse, what if investors sold near the bottom and were afraid to re-enter the market during the subsequent rally? These are very real (and highly likely) situations that occur when investing on emotion.

Risk Aversion

“There is one important caveat to the notion that we live in a new economy, and that’s human psychology.”

Daniel Kahneman and Amos Tversky, in their book Choices, Values, and Frames, showed that people strongly prefer avoiding losses to acquiring gains. In other words, people suffer from risk aversion. The pain felt from a $500 loss is far greater than the satisfaction from a gain of equal size. Therefore, people concentrate their efforts on avoiding losses.
In Kahneman and Tversky’s research, a sample of their undergraduates refused to stake $10 on the toss of a coin if they stood to win less than $30. The attractiveness of the gain was not sufficient to compensate for the aversion to the possible loss.
This behavior shouldn’t be too surprising, but things got really interesting when the researchers decided to challenge people on their beliefs by adding a related question—with a twist. They asked if people would prefer an 85 percent chance of losing $1,000 (and, therefore, a 15 percent chance of losing nothing) or a guaranteed loss of $800. A large majority preferred the gamble over the sure loss. This is risk seeking because the expectation of the gamble is inferior to the expectation of loss.
This shows a critically important point about human psychology and investing: Investors’ aversion to losses is so great that it overcomes their aversion to risk. In other words, people despise taking losses so much that they’ll overstep their risk boundaries in hopes of avoiding the loss. That’s perhaps the most dangerous of all combined approaches you could take to the financial markets. Unfortunately, it’s how we’re programmed to behave.
Short of wandering aimlessly through the mountains of Tibet searching for a Buddhist monk, can people completely detach from their emotions? Of course not. So what can they do?

Think Like an Entrepreneur: Use Technology to Override Emotions

Henry Ford used technology to automate the assembly line for cars, and he changed the world in the process. Michael Dell accomplished a similar feat in building computers with just-in-time production. Likewise, financial professionals have developed computer programs to handle the rote procedures of financial planning and investing.
Computer trading or program trading are computer programs doing the buying and selling. Large Wall Street firms may, for example, program a computer to sell one million shares of a particular stock if the Dow reaches 10,000, or buy 20,000 shares of IBM if the price falls below its 50-day moving average.
Many mutual funds take program trading to a whole new level and allow computers to manage their portfolios by buying or selling shares of particular stocks or indexes as long as certain conditions are met. Profits are taken and losses are limited to specified levels. In fact, every single financial decision is automated.
Computers are an excellent tool for investing, because they do things automatically (once instructed) and don’t have emotions. Investors are in the business of financial decisions, and there’s no room for the kind of emotions we’ve already discussed. Let’s look at the ways you can talk with a plan participant about automating their 401(k) and their investment decisions to avoid making costly errors and override their emotions.

Auto to the 4th Power

The goal is to turn your plan participants’ 401(k)s into Paychecks for Life. What follows are four powerful steps you can discuss with participants to automate their investing success and take the emotion out of the investing equation:
1.    Automatically enrollment in the 401(k) ensures that participants are on the road to securing their retirement.
2.    Automatic placement gives participants a default investment plan, protected through ERISA, which stipulates that the plan sponsor has a fiduciary responsibility to make prudent investment selections.
3.    Automatic escalation ensures that contribution percentages are increased by 1 percent each year until reaching the 10 percent maximum.
4.    Automatic rebalancing changes the allocation of assets across asset classes based on the portfolio performance, risk and the number of years to retirement.
By eliminating emotions from your participants’ investing and, instead, convincing them to opt for auto to the 4th power, participants jobs are easier. These processes won’t automatically bring success; however, they will make important decisions easier and more consistent for your participants. Adopting auto to the 4th power will limit the negative impact of emotions and that’s an automatic benefit for your participants’ Paychecks for Life plan and a secure retirement income.