Why People Get So Emotional About Gold

Getty Images

I recently wrote an article for CNBC about why I thought gold was going down. It was a pretty straightforward article, I thought, maybe even a bit dull with its echoes of Economics 101.

Well, I couldn't have imagined the response I got, which were mostly negative and angry. The experience made me wonder: why were so many people so upset with me for trying to explain why gold has been going down?

Gold peaked in September 2011 and the decline has accelerated recently, with the price down over 20 percent since last October. This is a fact. You would think that investors in gold would want to understand why it's falling so that they can decide whether to get out now or, if they think the reasons for the decline are wrong, buy more. So why get so upset? The answer to that has a lot to do with what makes someone a good investor. It's a lesson that everyone should learn if they are going to invest in anything.

(Read More: What the Silver Chart Is Telling You About Gold)

The reason is what behavioural finance calls cognitive dissonance. Cognitive dissonance is what you experience when you find out something that goes against your beliefs. The best example is the typical TV news interview with a murderer's mother. She always says what a good boy her son is, he would never do anything like that, he loves his mother, he loves his dog, etc. etc. This is normal. When faced with some new information that goes against our long-held beliefs, most people prefer to ignore the new information or rationalize it away rather than change their beliefs.

(Read More: Even Another Cyprus-Style Crisis Can't Save Gold)

The more time and effort people have invested in those beliefs, and the more costly it would be for them to admit that the new information is true, the greater the dissonance that they experience and the greater the need that they feel to reduce it. Reduce it not by changing their beliefs, but by ignoring or discrediting the new information.

So a mother, who's spent years and years raising her son and does love him, would naturally just refuse to believe that he's a murderer. And an investor who owns a lot of gold, subscribes to newsletters about gold, talks about gold with his friends, and has made a lot of money in gold in recent years, is likely to refute or reject any new information that says now might not be the best time to buy gold.

This is especially so because most people have a lot more confidence in themselves, their knowledge and their decision-making abilities than they should. I could see that in the responses to my article, some of which showed an imperfect understanding of economics at best.

For example, one reader who execrated me for saying bank reserves aren't money, argued that they are money because theU.S. Federal Reservepays interest on them, which ignores the fact that the Fed didn't pay interest on them before 2008, the European Central Bank currently doesn't pay interest on them, and the National Bank of Denmark actually charges a fee for holding them! Yet they were very confident in their opinion. Overconfidence is a big problem in investing.

Unfortunately, if someone does begin to feel unsure about their beliefs, then they usually won't try to learn more to see if their beliefs really are true. On the contrary, they'll generally take action to justify their existing beliefs. This is called confirmation bias. They will sort through the article and pay greater attention to any facts that support their position than the facts that don't. They'll try to find some small part that they "know" is wrong, and will therefore feel justified in ignoring the whole thing.

The important point to learn from this is that investors have to realize their own biases and tendencies and deal with them when investing. The market doesn't care what you believe any more than the rain cares whether you get wet. You can't let your emotions get in the way of your understanding the market, otherwise you can get swept away.

(Read More: Gold Bears, Beware! Don't Take On Central Banks)

Cognitive dissonance can be deadly when it comes to investing. When you're investing, it doesn't matter whether you are right or wrong; what matters is whether you make money. You shouldn't invest to prove something about yourself, to prove to other people that you're smart or that you're right, because at some point you're definitely going to be proven wrong. Some losses are inevitable in investing. It's not a shame. It's not a disgrace. It's normal. One of the keys to being a good investor is therefore to minimize your losses.

Confirmation bias can also be deadly. Naturally, it's more pleasant to read things that you agree with than things that you don't agree with. But if you don't try at least to understand why some people think differently from you, you're going to lose money sometime. It doesn't matter how smart you are; nobody can know everything. That's why stop-loss orders were invented. As the famous investor Howard Marks said, "you can't predict. You can prepare."

You have to have a plan before you go into a trade. You have to understand why you are taking a position, you have to have a target for how far you think it will go (since nothing goes up forever) and you need to decide on the stop loss level: the point at which you decide you were wrong and get out of the trade.

If you want an emotional experience, go on a date! Get married! That's where your emotions should come into play. In investing, our emotions are our enemies. We have to understand them and conquer them or else they can cause us to defeat ourselves.

The author is the Head of Global FX Strategy at IronFX, an on-line trading firm specializing in Forex, CFDs on U.S. and U.K. stocks, and commodities. He was previously Head of the Forex Committee at Deutsche Bank Private Wealth Management.