One of Warren Buffett's most quoted axioms urges investors to "be fearful when others are greedy and greedy when others are fearful."
Buffett's observation highlights the role emotions play in many investment decisions, as well as the way an unemotional investor can profit. But there's more to emotion in investing than fear and greed.
Researchers have identified more than 100 behavioral biases that can undercut effective investment decision-making, according to Michael Pompian, founder and partner at Sunpointe Investments and author of "Behavioral Finance and Wealth Management: How to Build Optimal Portfolios That Account for Investor Biases." In a course taught for the CFA Institute, Pompian identifies seven biases as the most common emotional influences on investment decisions.
Pompian says "loss aversion," for one, crops up when an investor is reluctant to sell a poorly performing investment and redeploy assets into a more promising opportunity.
"You're waiting in a bad investment because you can't face the fact that you're having to take the loss," he said. "The more rational approach is to take your loss, record the tax loss and move on to something that has better prospects."
Another emotion-driven hangup is called "anchoring." This can occur when an investor uses the price paid for a stock, exchange-traded fund or mutual fund as a reference point for decisions, Pompian said.
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A more rational investor would use an unemotional measure, such as price-earnings ratio. "The proper reference point is the proper valuation for the security, not what you paid for it," he said.
In advancing markets, overconfidence can become a problem emotion. "That's when the market is doing so well you're not paying attention to the underlying risk," Pompian said. "It's essentially unwarranted faith in your own abilities."
The challenge of emotion
Emotional influences on investment decisions can be hard to counter. Pompian said, for instance, that loss aversion is driven by a fear of negative outcomes that is twice as powerful as the lure of positive outcomes. Yet financial advisors say emotion-driven decisions are generally undesirable when it comes to investing.
"When we act based on our emotions, we tend to make bad decisions," said Jim Sandager, a certified financial planner with Wealth Enhancement Group. "Investors are better served by managing behavior and investing in a methodical way."
Sandager says that, from the financial advisor perspective, it's not enough to simply inform clients of techniques of successful investing.
"I've come to realize that the behavioral coaching part of this job is as important if not more important than the technical job," he said. "Helping people understand themselves and doing a good job of coaching them is really a primary role for me."
The role of technology
Unfortunately, the built-in nature of emotional biases means that it's difficult for many investors to recognize when investment decisions are being driven by emotion. However, recently, facial analysis technology has been applied to help investors recognize their own hard-to-spot emotional responses.
Cetera Financial Group of Los Angeles recently began a pilot program using facial analysis to augment the usual questionnaires administered to determine emotion-connected variables, such as a client's risk tolerance. Clients respond to questions about scenarios, such as market declines, in front of camera-equipped laptops and tablets. Software analyzes their facial expressions and provides insight into emotional reactions.
Discipline is the key to successful investing. Behavioral biases get in the way of following a disciplined plan.Michael Pompianfounder and partner at Sunpointe Investments
The technology, called Decipher, helps identify emotions that clients may not be aware they are experiencing or may feel pressure to disavow when filling out conventional written questionnaires, says Robert Moore, Cetera's chief executive officer.
In addition to improving accuracy and client experience, Decipher and other technology advancements boost efficiency, allowing advisors to support up to three times as many clients, Moore says. "Where before they could have 200 clients, now they could have 600 or 700," he said. After concluding the pilot in late 2017, Cetera expects to gradually roll it out to all of its 8,000 financial advisors.
Responding to emotions
Once an emotional influence is identified, the proper response is not necessarily to deny or block it. Sandager at Wealth Enhancement Group says he trains clients to realize that emotions often influence investment decisions and to be aware when they are coming into play. "It's okay to feel emotions," he said. "That's normal."
Then he added: "But realize that it's not rational or logical."
The optimum response to emotion in investing is to acknowledge it without, if possible, allowing it to cause an investor to deviate from the financial plan that has been created to help advance the investor's goals. "Discipline is the key to successful investing," said Sunpointe's Pompian. "Behavioral biases get in the way of following a disciplined plan."
A further complication is that advisors, being human, can also fall prey to emotional biases. Pompian says investors can assess an advisor's susceptibility to emotion by looking for evidence of a systematic approach to investing.
"One simple way is to ask your advisor, 'Do you manage your client relationships using an investment policy statement?'" he said. "If so, that's a good sign."
— By Mark Henricks, special to CNBC.com.
