How to Take the Emotion Out of Investing

Jan 24, 2024

Recognizing your impulses when investing can help you sharpen your decision-making. Here’s how.

Author
Christopher K. Baxter
Christopher K. Baxter

Key Takeaways

  • Behavioral finance, which combines economics and psychology, can help investors identify and avoid unconscious behaviors that may lead to poor decisions.
  • Strategies such as referencing a “base rate” and conducting a “pre-mortem” can help investors manage their expectations and weigh possible outcomes they might otherwise overlook.
  • During stressful periods, guidance from a financial professional may help you stay on track and avoid adverse short-term decisions.

While investors have more data at their disposal than ever before, making the right investment decision takes more than just crunching numbers. Investors must also understand the psychology of the market—as well as their own impulses—to help sharpen their rational decision-making process. This is especially during periods of market volatility, when emotions often get in the way.

 

“Behavioral finance” is a field of study that combines economics and psychology to help inventors identify and understand certain behaviors, often unconscious, that can lead to inopportune investment decisions. To understand how professional investors use behavioral-finance tools and frameworks to make smarter decisions, I recently spoke with Michael Mauboussin, head of research for Counterpoint Global, a growth-oriented global equity investment fund from Morgan Stanley Investment Management.

 

“Almost all behavioral-finance strategies have one thing in common: getting us to open our minds and think about things we wouldn’t have otherwise thought about,” Mauboussin said. “They’re not complicated, and they’re often key to reducing risk and avoiding mistakes.”

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Q
One strategy you’ve mentioned is using a “base rate.” What is a base rate, and how do you use it to improve your investment decision-making?
A

Let’s take a step back and look at the two ways that people make decisions in general. The first can be considered the “inside view,” in which you gather a bunch of information about your problem, combine it with your own experience and project it into the future. Left to our own devices, that’s what most of us do.

However, there’s another approach that can be categorized as the “outside view,” which, in investing, is known as establishing a base rate. The idea here is to think about how similar situations have unfolded in the past.

Take the example of a hot stock for which an analyst is projecting 30% sales growth annually for the next decade. Taking the base-rate view, an investor would ask: How many companies of a similar size and market have grown 30% per year for 10 years? In most cases, we’re talking about a very small handful of companies. So, while this 30% growth scenario is not outside the realm of possibility, the base rate would indicate that it is wildly optimistic.

By integrating the idea of a base rate into your thinking, you can consider a different perspective to help you make more accurate forecasts and manage your expectations about how an investment will perform.

i
Integrating the idea of a “base rate” into your thinking can help you make more accurate forecasts and manage your expectations about how an investment will perform.
Q
You’ve written about using “pre-mortems” to help evaluate a potential investment decision. Most people have heard of post-mortems, but what is a pre-mortem?
A

In a post-mortem, we look at what happened, after the fact, to determine what we should do differently next time to create a better outcome. This can be particularly useful after a decision has gone poorly, because it can help us avoid making the same mistake in the future.

But with a pre-mortem, you pretend you’re about to make an investment decision and then imagine a future in which that decision has turned out poorly. You then try to come up with as many reasons as you can think of as to why that decision didn’t work out well. This exercise can help open your mind to all the different alternatives that you might not have otherwise considered.

So, as a hypothetical example, if you are considering investing in a hot AI company, you might ask yourself, “What could go wrong?” and perhaps list the possible adverse scenarios. These could be potential volatility for tech stocks broadly, or the possibility that regulatory changes dampen growth in AI specifically, or the risk of competitors out-innovating the company.   

Ultimately, a pre-mortem may not necessarily change your mind about your investment decision, but it’s still a very useful mental exercise. It can help you prepare for all the various contingencies that you might not have otherwise prepared for if things do go wrong, allowing you to pivot faster if necessary. 

Q
How do you know when to follow the crowd? You’ve written about both the “wisdom of crowds” to describe when markets operate efficiently and the “madness of crowds” to describe when things go haywire. How can investors tell which is which?
A

The “wisdom of crowds” is the idea that large groups of people collectively are smarter than any one individual. In investing, it requires three things to go right: a diversity of perspectives among the different market participants, a properly functioning market and incentives for being right.

The “madness of crowds” occurs when one or more of these conditions is violated. In investing, it’s often diversity of thought that’s missing—so, rather than a buyer and seller thinking differently, they are aligned. A lack of contrarian thought can lead to significant market distortions, such as the dot-com bubble in the late 1990s, the housing bubble that led to the Great Recession in the 2000s or the meme-stock craze in 2021. These episodes all ended poorly for markets. For investors, a Financial Advisor is often a great resource for getting a second opinion so you can avoid getting caught up in the madness of crowds. 

Q
Can you talk about the role that stress plays in decision-making?
A

Think about the role of stress in biology. If you’re a zebra and see a lion that decides you’re a target for lunch, your physiological stress response kicks in. This causes your adrenaline and heart rate to spike and makes you singularly focused on surviving today, not months or years from now.

Similarly, for investors, stress impedes your ability to think about the long term. So, while there may be fabulous investment opportunities beyond the horizon, stress can prevent you from being able to look out that far.

Think about a market crash when prices are low. Intellectually, this is the ideal time to buy assets because they’re so cheap. But the stress of the market’s crash and its impact on your portfolio can instead lead you to avoid doing anything or, worse, sell at the wrong time.

This is where a Financial Advisor can be incredibly helpful. They can keep their eye trained on the long-term horizon, knowing your ultimate financial goals. This can help keep you on track and avoid making short-term decisions that may be detrimental to your long-term returns. Because ultimately, achieving the results you seek is just as often about reducing errors as it is about picking winners. 

Working with your Morgan Stanley Financial Advisor or Private Wealth Advisor enables you to have someone who understands your goals and is looking out for your future. Connect with your advisor today to discuss how you can make more informed decisions in the face of market uncertainty.

 

The webcast was presented by Morgan Stanley Private Wealth Management and Morgan Stanley International Wealth Management, which offer a variety of unique, digital and in-person client experiences to help you enrich your understanding of key issues facing affluent families, network with peers and learn from experts from within and outside the Firm.

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