Want to make money in the markets? Get your emotions in check!

We hear all the time to control your emotions when investing, yet there is endless data that suggests most investors (professionals included) have a very hard time actually doing so. 

Making decisions while you’re emotional can lead you to some bad choices. This is especially true when the decision has complexity to it. Like buying or selling an investment. 

Think back to the last time you made a really bad decision. Maybe something you said to someone out of anger or sadness. When you look back, if you had control of your emotions do you think you could have found a better way to deal with the issue at hand? I know upon my own reflection that the answer is almost always a yes.

Investing is no different. Whether we’re excited about a big gain or sulking in the corner over a significant loss, succumbing to our emotions can lead us to make poor decisions. These investor emotions play a large role in stock market booms and busts. Investors pile in after hearing their friends or colleagues make a lot of money on stock x, driving the price up further. On the flip side investors run for the hills when markets drop off, with many selling every investment they own going completely to cash. Just like how we say things we may not mean in the heat of the moment, we can make buy or sell decisions that are detrimental to our wealth creation purely because we made the decision while being under the control of our emotions.

In order to better understand how to deal with this I think it makes sense to dive deeper into the two major emotions that have been observed in the markets since the beginning of their existence. Fear and greed. Let’s start with greed. 

Greed is defined by google as “intense and selfish desire for something, especially wealth, power or food.” I think it’s no coincidence that both wealth and food are listed in googles definition. The greed for future money or profits is similar to our desire for food and is deeply rooted in our biological makeup. Our brain actually treats investing or gambling very similar to other basic rewards like food, drink, shelter, sex, drugs and so on. We find out at a young age that money is vital in the acquisition of our basic needs. Because of this the reflexive part of our brain (responsible for emotions) responds to financial gains similarly to other feel-good experiences. Peter Kirsch, a neuroscientist at Justus-Leibig- University in Germany is quoted in the book Your Money and Your Brain saying “Even though money cannot satisfy any primary needs – you can’t eat it or mate with it – the association between money and reward is very strong.”

The tricky part about greed is that it is mostly felt prior to receiving a gain. Making money does feel good, just not as good as anticipating making money. From studying the activity in our brains, neuroscientists have found that when someone purchases a stock, the reflexive part of our brain is highly activated with the hope of future profits. When the profits arrive, our brain is still activated. Just not as much as when we were anticipating the gain. After all we had expected the stock to rise otherwise we would not have bought it. The excitement we get from the anticipation of receiving the gain far outweighs the actual gain itself. This key difference to how our brain is activated prior or after the gain has major implications on our financial behaviour.

This biological mechanism can explain why we see so many investors act irrationally plowing large sums of money into highly speculative investments. Think dot-com bubble or if you’d like a more recent example, I’d argue that bitcoin and many of the cannabis companies fit the bill. Once the anticipation of profits become profits, investors need to find their next fix in anticipating another future gain. In many cases this can mean putting money back into the same speculative investments they lucked out on in the first place. This explains the lottery stats in Ohio, where 82% of people who have won at least $1,000,000 continue playing the lottery on a regular basis after winning. 

Why does the reflexive part of our brain enjoy the anticipation of the gain more than the gain itself? Neuroscientists from Ohio named it “the seeking system.” Through millions of years of evolution, the thrill of anticipation places our senses in a high alert state, which helps us when chasing uncertain rewards (think hunting and gathering). Paul Slovic of the University of Oregon, titled this activity as “a beacon of incentive.” It helped to condition humans to pursue long term rewards that could only be earned through patience and persistence. If we did not receive pleasure through anticipating rewards, we’d never get off our butts and take action in the hopes of receiving them. In the hunter and gathering example, it is a very positive trait, as without it humans would have perished.

Next up is the emotion of fear, defined by google as “an unpleasant emotion caused by the belief that someone or something is dangerous, likely to cause pain, or threat.” It’s easy to see from the definition above, why we react to fear. Who the hell likes feeling pain! When people sense a threat or are feeling pain, they typically will move away from it. This is natural and rational in most cases. If you were to burn your hand, I’m sure your initial reaction is to pull away. 

Above your ears is a small part of the brain known as the amygdala. Part of your reflexive brain, the amygdala acts as an alarm system that alerts you to danger using emotions of fear and anger to get your attention. Something that is out of place, changing quickly, or something scary will set off your internal danger alarm. Years of evolution have given purpose to this reaction. If I spot a saber tooth tiger out of the corner of my eyes or an oncoming car in the wrong lane, I’d prefer my amygdala to take over and alarm me that I’m in danger, versus thinking through whether or not I need to run. Fractions of seconds could mean life or death in many cases. And since we’ve determined that money is associated with survival and basic needs, this would explain why the amygdala feels threatened when we experience or even think that our investments may lose value. This leads many investors to do the ol’ “Buy HIGH and sell LOW” despite knowing that this is the exact opposite of what we should do. Investing is a lot different and more complex than running from a saber tooth tiger or swerving away from an oncoming car.

You may be thinking “great, my brain is hard wired to make me TERRIBLE at investing. I can’t change millions of years of evolution.” You’re right, you can’t. But knowing and understanding why our brain creates the emotions we feel is the first step towards managing them better. Managing your emotions is a prerequisite to long term sustainable performance in investing. Without the ability to manage your emotions you will undoubtedly fail, and lose a lot of money in the process. Below I’ve outlined some tips for dealing with both “greed” and “fear” taken from Jason Zweig’s book Your Money and Your Brain.

Dealing with Greed

Lightning Seldom Strikes Twice

• If you’ve made a bunch of money on a stock pick, chances are you will be tempted to chase that feeling again, your brain will crave it. It’s easier to spot stocks that have already gone up and a lot harder to pick the ones that will go up in the future. You should only take large positions in single stocks if you have studied the underlying business carefully and would be fine owning the company if the stock market shut down for five years.

Set Aside Fun Money

• If you can’t help yourself and you love the thrill of dabbling in the markets, watching your stocks go up and down, fine. But set aside a specific amount that if you lost, it would not affect your current lifestyle or your future goals. The rest should be well diversified and invested in a way that will allow you to not react to every up or down the market throws your way. 

Create a checklist of standards

• Checklists help you to re-asses your decisions and can act as a way to alarm you if you’re straying from your investment philosophy. If something does not meet the criteria that you set out while your emotions were in check, than it’s most likely an investment that you should walk away from. Discipline is important otherwise you’ll hop around from investment to investment with little success, and less money.

Dealing with Fear

Use Words and Ask Questions

If you’ve purchased shares in a company or any investment and it drops, chances are your brain is going to feel pain. You are human. Ask yourself questions like:

• "Other than the price, what else has changed?"
• "Are my original reasons to invest still valid?"
• "If I liked my investment enough to buy it at a much higher price, shouldn’t I like it even more now that the price is lower?"

Hopefully you’ve learned a bit on why your brain reacts the way it does when making investment decisions under the influence of fear and greed. Whether you’re working with an advisor or handling things yourself, emotions will arise. Understanding your emotions and using some of the tips above, or developing your own, will only help you to make better decisions. Ultimately this will make you more money with your investments. Good luck. Get your emotions in check!

-         Brandt Butt

National Bank Financial - Wealth Management (NBFWM) is a division of National Bank Financial Inc. (NBF), as well as a trademark owned by National Bank of Canada (NBC) that is used under license by NBF. NBF is a member of the Investment Industry Regulatory Organization of Canada (IIROC) and the Canadian Investor Protection Fund (CIPF), and is a wholly-owned subsidiary of NBC, a public company listed on the Toronto Stock Exchange (TSX: NA).

The particulars contained herein are intended to provide general guidance on matters of interest for the audience who accepts full responsibility for its use, and is not to be considered a definitive analysis of the law and factual situation of any particular individual or entity. As such, it should not be used as a substitute for consultation with a professional accounting, tax, legal or other professional advisor. This commentary reflects my opinions alone, and may not reflect the views of National Bank Financial Group.