How Emotional Investing Affects Your Bottom Line

How fear, greed, and ignorance can impact your bottom line.

By SHARE

Despite all the numbers and calculations that go into investing, many decisions are informed by nothing more than a gut feeling, a hunch, or sheer panic. Behavioral finance guru and professor Meir Statman has spent his career analyzing what makes average investors tick, and explores the emotions and thought processes that drive their investment decisions in his new book What Investors Really Want. U.S. News asked him to weigh in on the challenges investors are facing and how to keep a level head in an uncertain market. Excerpts:

With QE2 threatening to drive domestic bond yields even lower, many investors are flocking to foreign fixed-income options that offer better returns. What's your take on that?

It's a terrible idea to try to chase [yield or performance]. Think of the story of Italian investors who were unhappy with the low interest rates in Italy in the early 90s. They invested in Argentinean bonds that had higher rates of interest, and you know what happened next? Argentina defaulted on its bonds. Sometimes there are very good reasons why interest rates in one country are higher than others.

Whenever you buy something, whether it is yen or euro or whatever it is, there is somebody on the other side of the tennis net. If you are so smart then the other person must be stupid, and if you just consider the possibility that the other person might be Goldman Sachs, I hope that gives you pause.

[See How QE2 Could Affect Your Money.]

There's nothing wrong with buying foreign bonds—just like buying foreign stocks as part of a diversified portfolio—but anytime you try to get some specialty product, it's really like getting a bespoke suit. If it has to be just right for you, it means it's going to cost you $2,000, at a minimum, rather than $500 for a decent ready-made suit. So you have to know that what you might be gaining, you're likely to lose because of the extra cost.

Then what should people do in this market environment?

Some people say "Don't just stand there, do something," and I say "Just stand there and don't do anything stupid." People should have a well-diversified portfolio between stocks and bonds. This means, for example, that they are going to have a portfolio that includes both foreign stocks and domestic stocks. Foreign stocks have a built-in protection against declines in the dollar. You have it right then and there. There is really no reason to build layers upon layers. Investors should stop trying to figure out where interest rates are going and when. It might be they're going to stay low for many years. What you really need to do is not try to outguess the market.

[See What Foolish Investors Believe.]

What's making people pile into commodities such as gold?

In the same way people tell you who they are and what they like by what they wear and which car they drive, they also tell you that in the investments they make. If you ask yourself who is buying gold, they have a more pessimistic view of where we are and where we are going.

What is happening is that people are afraid, and when people are afraid, they draw in. They become very risk averse. They see reasonable-sized risks as being giant risks. We always have to prepare somewhat for bad things that can happen, but getting to a position where you put all your money in gold is really an unreasonable fear and an unreasonable kind of response.

[See Gold May Rise, But Is It Safe?]

What's the best piece of advice you can give investors today?

People behave in ways that often are not doing them much good and often act against them. [One reason is] because they make mistakes. They don't really ask themselves whenever they want to buy something, "Who is the idiot on the other side?" If they did, [they might think] it might be Goldman Sachs and maybe they know something I don't know rather than the other way around. So just understanding the nature of the game is one thing. Also, you have to be sensible. You might want to be rich. You might want to be rich so much that you're willing to put all your money in lottery tickets, but that's not really sensible.