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.
RIC: Which is, of course, absurd.
DENISE: Right. But each decision is very much influenced by the emotion of your last result. So even if people didn't sell anything this week, they may have looked at their account every day or several times a day, and that functions neurologically as if you actually made that decision. Mentally, it costs you money. Now you are upset, and you are afraid. And it does really drive you, if you don't know this new way of working with emotions, to feel compelled to get out.
RIC: Many folks don't consider themselves to be investors, but rather consumers who are trying very hard to save for their retirement, get their kids into college, care for aging parents and enjoy future financial security. So they are investing, but they don't think of themselves as investors -- if you get my meaning. And they are scared. What should they be doing right now?
DENISE: First, realize that what they need to do is rethink their thinking about emotions. Emotions can really help you. They can protect you, if you learn how to use them that way. So what you've got to do is say, "Hey, I can feel something, but that doesn't mean I need to act on it. And when I feel something, I just need to pay a lot of attention to myself and go inside and research."
By the way, this applies to everything in life, because it's the way the brain works. Often, you'll find that there is something behind it, something bigger, more catastrophic, more worrisome that isn't really reality. When you go through this process, your brain seems to open up, and you realize it's not really the end of the world. For example, you don't need the money for 10, 15, 30 years, and you don't really need to do anything. But most people want to do something in order to expend the energy that the emotions are giving them when these emotions are instead really designed to help you understand your situation better.
RIC: You are raising a very important point. What about rationality?
DENISE: The quickest way to get rational is to get emotional, because if you incorporate that emotional information, you actually will end up with a more rational decision. But none of us have been taught this because we've only discovered this in the last five to 10 years. We don't know how to make our emotions work for us. Emotions literally are physically uncomfortable.
I liken it to being in the dentist's chair. They've got their hands in your mouth, and you are wondering "when will this be over?" But in a dentist's chair, you know it will be over in 20 minutes. And when you pay attention to the emotions, that little physical discomfort tends to go away, and your brain really does start to work with, "OK, what are my options, what are my alternatives, and do I really need to do anything at all or should I just look the other way?"
RIC: Then the best action is, in fact, no action?
DENISE: I think so, yes.