Emotions and Decision-making

Some time ago, one of my colleagues wrote a three-part white paper on how emotions can affect our decision-making processes.  How it is next to impossible to remove the emotional bias from everyday decisions when it comes to finances.  There was much discussion about how our brains process information and the paper even described the two sections of our brains that controlled specific functions.  Although the brain uses both sections very efficiently most of the time, one of the sections of our brains is reasonably accurate at making short-term predictions and reacting to challenges.  However, it has biases, systematic errors or short-cuts that affect specific situations.

These biases include things like loss aversion and conservatism.  They also include a hindsight bias, an anchoring bias, a recency bias, a bandwagon bias, as well as, an overconfidence bias.  They even include decision paralysis and the status quo bias.  The bottom line is that while our brains are completely amazing in so many ways, without understanding and identifying how and why we may make decisions, they can leave us very vulnerable when it comes to financial matters.

I was reminded of all these emotions this month as we were dealing with the “Brexit” issues.  I started thinking about how each client was taking in the information and processing it in their own personal way.  Their past experiences, both good and bad, and how those would influence how they thought this issue would play out or what should be done about it.  Many of my conversations came back to the question “what do we do now?”  In some situations, a change was needed, as these types of situations can help reinforce what someone’s real risk tolerance is.  However, most of the conversations came back to the basic question: what has changed with regards to their long-term goals that would warrant a complete overhaul in the strategy?

This is not a new topic, and I am very aware of all the biases that must be overcome when trying to apply a consistent strategy to a long-term goal.  But, I am not sure I had actually heard the term short-termism.  The definition refers to an excessive focus on short-term results at the expense of long-term interests.  In many situations, it seems the entire investing community has this problem.  Shareholder value is thought to be created on a quarter by quarter basis.  And some analysis of the global economic downturn suggests that the short-termism in regards to financial institutions and lenders are certain to have been part of the root cause.  Accounting driven metrics and profit maximization can’t always fully reflect the complexities of corporate management and investment, but these short-term hurdles can all too often cultivate misleading conclusions.

Without acknowledging how our brains work and overcoming the “fight or flight” emotions and our biases, we are hard wired to be terrible investors.  And one of the most dangerous of all behaviors just might be called short-termism.  That’s a fitting way to describe a number of destructive actions: making decisions based on recent gains or losses, quickly turning over positions based on current news, making “fast money” trades and speculations, or overhauling an entire long-term plan based on short-term events.

It’s okay to use your emotional side as a factor to help evaluate where you may fall on a risk-reward spectrum or to help determine what may be a suitable mix of stocks, bonds, and other assets for you.  However, take a moment to stop and recognize all the biases that lurk in our minds and avoid letting reactive behavior be our own worst enemy.