Emotions and investment decisions are supposed to be mutually exclusive. At least that's what conventional wisdom says. But recent discoveries in neuroscience and behavioral finance show that emotions can serve as an effective tool even when making the most important rational decisions.
To learn the role emotions can play in finances and how poorly managed feelings contributed to the Panic of 2008, I interviewed Denise Shull, president of TraderPsyches, a firm that coaches commodities traders to successfully use their emotions in their decision making. With a master's degree in neuroscience from the University of Chicago and 15 years of experience as a trader at the Chicago Mercantile Exchange, Denise offers tips for interpreting emotions as though they were any other piece of information. A modified transcript of the interview follows:
RIC: We clearly witnessed panic in the financial markets this year. Are you surprised?
DENISE: Not at all. We've learned in the last five years or so, from being able to watch brainwaves as people make risk/reward decisions, that emotions actually form the foundation of all of our decisions and all of our actions. And we really need them.
This is a new perspective, because we've all been taught that we need to keep emotion out of our financial decisions. But that strategy can't work because it's not really the way the brain works. If we try to ignore emotions, they actually get bigger than they would if we relearned how to use emotions the way the brain has designed them to be used.
RIC: So neuroscience takes behavioral finance to the next level?
DENISE: Yes. For example, we put experimental subjects, mostly college students, in an MRI machine and took pictures of their brains while they played a simulated stock market game. When you look at those pictures, you find out that the emotional circuits, to the extent that we understand what emotional circuits are, are firing as much as two full seconds before they actually make their decision about which stock or bond they are going to buy in the simulation.
RIC: Historically, the investment advisory community has said to clients, "Put your emotions aside. Be intellectual." And you are saying that that is ridiculous, that we can't tell ourselves to throw our emotions aside?
DENISE: Exactly. The trick is to think of your emotions first of all as information. And remember that a feeling and an action are actually two separate things. If you try, you can separate the two.
Fear can be a perfectly reasonable, rational response to what has happened in the market. But then you say "OK, I'm afraid. What's really driving my fear?" And usually what people find is they are imagining a truly catastrophic situation. But they don't know they are imagining that until they really look at the emotion. And it's that fear of the catastrophic situation that then causes them to take an action, i.e., selling, probably at the worst possible time.
RIC: In other words, what they are doing is extrapolating, and they don't realize that their fear is based on their presumption that the market will drop all the way to zero.
DENISE: Exactly. I've had two people ask me, can it go to zero? They were serious.
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