Emotion Can Make You a Bad Investor

The author of Your Money & Your Brain says feeling you've got the market figured out can be addictive.

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Investors often make choices that make no logical sense but perfect emotional sense, argues financial journalist Jason Zweig in his new book, Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich. He spoke with reporter Emily Brandon about how to overcome your brain's natural urges to become a better investor.

When investors experience a monetary loss or gain, what kind of physical effect does it have on the body?

The brain processes expectation in a much more intense way than it processes the actual experience. So, the hope of making money often feels better than actually making money does, and the fear of losing money often feels worse than actually losing money. And those are the two states that often drive your behavior.

Why do our brains respond so powerfully to money?

The human brain developed to solve the very simple problems of finding food and shelter, courting mates, and avoiding danger, and our ancestors had to make simple calculations about risk and reward, all in the absence of money. In the modern world, almost every risk and reward that a human being faces is either symbolized or mediated by money. Money is not a reward in itself, but there are very few rewards you can get where you don't need money. Money taps into the most ancient and powerful emotions that the human brain can experience, and because of that I think a lot of people, when they are making financial decisions, really feel they are thinking and deliberating. What they often don't realize is they are really deciding with their emotion.

How can you prevent being knocked off track by your emotions?

Have policies and procedures in place in advance so you don't jump from decision to decision. You shouldn't make your choices based on what the stock market is telling you and based on what other people are doing, but rather on the basis of rules you are putting in place in advance. You can invest with a rule or a procedure, such as I will always keep 70 percent of my money in the stock market, as an example. If you committed in advance, when the market crashes as it did this summer, you will find that you have less than 70 percent, and that means that you must buy more. In general, if you buy when most of the news is about how everyone else is selling, you'll probably do much better. A rule that forces you to go against what your emotional brain is telling you is almost a certain way to get better results.

When investing, should you discard your first impulses altogether?

Many people should. Investing should be as close to an automatic process as you can possibly make it. For many people it's more like a hobby. They see something they like so they buy it, or they find out something they don't like so they sell it. It's a lot like collecting Beanie Babies. You should have policies for making very broad and very simple decisions. The more you can make it a policy and an automated process, the less likely you are to have your emotions be hostage to the state of the markets and the 100 million other people who are investing alongside you. Because if you take your impulses from what they are doing, you'll always be as crazy as they are.

Why are most people convinced they can find patterns in the stock market and make predictions?

The excitement you feel from thinking you are going to make money is very intense. If you've made some successful bets in the immediate past that have paid off more than once, you will really come to believe that you've got it all figured out. This sensation that I'm hot or I'm on a roll can lead to incredible euphoria. It also can be basically indistinguishable from a form of addiction. If you look at the brain of someone who has gotten a few stocks picks right in a row, it is almost indistinguishable from that of a cocaine addict, because the sensation is processed in the brain in almost the same way. You almost become addicted to the belief that you know what you're doing, and you may not know you're in the grip of these feelings.