Is investing emotional or logical

I subscribe to the belief that Investing is a science and that successful investing actually happens with elements like logic, research, process and discipline as opposed to things like luck, inside tips and intuition. That being said, I also believe that emotions also play a very important role in your investment decisions.

Two basic theories of investing

  1. Traditional Theory of Investing. The most basic traditional theory of investing says that markets are rational. Science, logic, math statistics, and research rule the day. Build a framework and a process and the discipline will ensure that you have a good investment strategy. Asset allocation, risk-reward tradeoffs, value investing and good research will lead you in the right direction. How can you argue with greats like Warren Buffett, Peter Lynch and Sir John Templeton.
  2. Behavioral Finance. More recently there is more attention being given to behavioral finance experts that believe markets are not rational. Rather markets are driven by the behavior of investors, which are by and large driven by emotions.Proponents of behavioral finance think that people spend too much time studying investment behavior and not enough time focusing on investor behavior. It is their belief that regardless of what an investment does, it is the decisions of the investor to buy or sell that ultimately determines success or failure.Behavioral finance is about the odd behaviors that we exhibit when it comes to money. It took a very logical premise about the tradeoff between risk and return and added psychology.

So is the investment industry in a quandary? Which theory makes more sense? Is investing emotional or logical?

Up DownFor me the answer is both. You cannot have one without the other. I know that seems like a cope out but think about it. In my education and training, I have mostly been taught on the science of investing. I have always believed that investing is about good research and analysis. I’ve always said that my role with clients is to crunch numbers and understand the logical side components of investing.

However, every bear market reminds me about how powerful emotions are when it comes to investing. No matter how many logical arguments you throw at investors, it was emotion that made the final decision. The last three years have proved to be the most emotional and irrational period in history. Investors continue to buy when investments and markets go higher and sell when markets are low.

I believe there is a continuum where on one end you may believe that markets are efficient and logical. On the other end markets are irrational, random and unpredictable.

While I still subscribe significantly to the theories of logic, research and science, I also believe that emotions cause investors to be irrational decision makers. The problem of course, is that emotions can be very unpredictable.

Are you an emotional or logical investor?

Take this simple 3 question exercise to see which one plays a bigger role in your investment decision making process.

  1. When is the most rational time to buy?
    • When the market is up 30%
    • When the market is down 30%
  2. When is the scariest time to buy?
    • When the market is up 30%
    • When the market is down 30%
  3. When is the safest time to buy?
    • When the market is up 30%
    • When the market is down 30%

Chances are when you thought about it and rationalized it in your head, you came out with some pretty logical answers. However, the fact is that most investors do the opposite of what is logical.

I still think the secret to investing is to remove emotion from your decision making process. However, I also know that is not always a realistic expectation. Do your best to be logical and when in doubt, take a moment to think it over before you react.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace.For more information you can follow him on Twitter @JimYih or visit his other websites Group Benefits Online and Advisor Think Box.

2 Responses to Is investing emotional or logical

  1. As an ultra-conservative, very timid investor, I agree that emotions have a big role in investing. We approach it in a slightly odd way. Generally, we only buy a stock we feel comfortable holding for 3-5 years if we have to because it goes down in value for a few years before coming back up. This means it has to pay a dividend at least as good as a current GIC one-year rate. This helped us, for example, with our buy of BNS. It promptly plummeted after we bought it, and only now years later is it within kissing distance of the price we bought it at. However, we didn’t panic into selling it at a loss, because it pays a reasonable dividend, and we feel confident that over the long term it should re-bound to what we paid for it. Emotions can trump logic, as you say, so having a strategy to help cope with emotions may be helpful.

  2. Thank you for choosing such an interest subject. I think there is no safest time to buy the stocks /equities – it simply does not exists.

    What ever you do bears the risk to loose all your money. People are both emotional and logical. A lot of time we are safeguarded by our ignorance – people simply do not pay attention to their investments in the pension funds and so on.

Leave a reply

Notify me of followup comments via e-mail. You can also subscribe without commenting.

Headline Name: Email: subscribed: 0 We respect your privacy Email Marketingby GetResponse