Emotions Can't Be Controlled, but Actions Can


Gotcha! That's what the market said to all those investors who panicked and sold, out of fear, on the way down last week.

And guess what? The ones who panicked most were the professionals. They're supposed to know better. After all, they're paid to manage money in the markets. But it was the pros who executed those huge block trades just to get the financial companies off their books before the third-quarter reports go out.

The pros pulled millions, even billions, out of money market funds because they worried not only about Lehman Brothers paper, but about the entire corporate borrowing market.

Professionals around the globe panicked and piled into Treasury bills, pushing yields sharply lower, just as the Treasury was creating billions of dollars in bailout credit that is certain to swamp the value of the dollar -- unless, of course, it disappears down the black hole of defaulted swaps and writeoffs.

Ordinary investors became the, relatively speaking, smart money. Perhaps it was fear that paralyzed many people and kept them from selling instantly. Or maybe it was because they use mutual funds, and knew that the daily prices are set after the close, causing them to pause and pray for a rebound.

This is not an argument that buy-and-hold always works. The impact of the financial crisis will certainly take its toll on the broader economy, and there's a good chance stocks will move lower to reflect that.

But it is an argument that smart investors resist those two emotions so closely tied to human nature: fear and greed. Greed got us to this point. Fear destroyed billions in assets instantaneously.

On a more sophisticated level, experts in the field tell us that resisting emotion isn't just about self-discipline. The science of "radical neuroeconomics" explains how feelings and actions are related.

"It's a myth that you can control your emotions," says Denise Shull, president of Trader Psyches, a New York consulting firm specializing in teaching better methods for making decisions in the financial markets. "Neurologically, you can't. But what you can control is your actions, if you understand what's really driving your emotions."

In short, she and her staff of three modern psychoanalysts work with traders to teach them how to use their emotions to their advantage.

How did those teachings work this past week? "The emotional networks in the brain fire long before the analytical networks in the brain," she says. "Feelings are information and motivation. But they don't have to automatically result in action. The trick is to view those emotions as information, allow yourself to understand and identity your feelings, and only then make a fully informed decision."

This process involves more than trading discipline, she explains.

"The markets plug right in to people's deepest insecurities at the core level and cause you to feel emotions that are way out of proportion to what's happening," Shull says. "When you try to control those emotions or deny them, inevitably that energy will push you into taking an action that, in retrospect, will always be irrational, and expensive."

And, says Shull, that's as true on the most sophisticated trading desk as it is for the individual investor.

So how did you deal with the emotions of this past volatile week in the financial markets? What did you do, or not do, that you now regret? What will you do differently the next time around? These are not idle questions, because this is certainly not the last market crisis.

For the ordinary investor, the best strategy, according to legendary gurus such as Vanguard's John Bogle and economist Burton Malkiel, is to just go along with the market in an index fund. Malkiel, author of A Random Walk Down Wall Street, says that only a minority of managed equity funds have succeeded in beating their benchmark indices.

Over the long run, the market has historically exceeded the returns of T-bills and CDs. So exposure to stocks is necessary to build a retirement portfolio. The only real issue that should be decided in advance is asset allocation -- the amount that should be placed in stocks or bonds or safe cash equivalents. That's a decision best made in a calm moment, not in the midst of turmoil.

But what happens when ordinary investors and even professional traders are suddenly confronted with volatile markets? Long-term planning, asset allocation and determined self-discipline go out the window. Emotion rules. Then they're sorry. And that's the Savage truth.

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