Tuesday, December 4, 2012

Emotions and Rational Thinking in Investing

There is an uneasy relationship between emotions and rational thinking in investing. I’m a believer in using careful rational thinking when making big life decisions like how to invest your life’s savings, but it isn’t possible to keep emotions out of the equation entirely because most of life’s core goals are fundamentally emotional.

To the extent that I have any philosophy in life it would be “sustainable happiness”. Without the sustainable part, drugs would be a good solution to produce a burst of happiness. But this is hardly sustainable. So, I try to eat well, get regular exercise, and treat others well in a bid to be happy for the long term. The pursuit of money is not an end in itself, but a means of achieving freedom, comfort, interesting experiences, and ultimately, happiness.

There are those who say that money doesn’t matter. They are partly right and partly wrong. Of course money matters, but what you give up for it matters too. I’ve consistently turned down career opportunities because they would have demanded so much time that my connection to family and friends would have suffered. In these cases, I would have said that the extra money doesn’t matter. I sometimes see people justify extravagant spending saying something like “money doesn’t matter” or “you only live once”. In these cases I think these people are usually reducing their future happiness.

So, despite the fact that success in life is best defined by emotions, I think it pays to keep emotions out of your decision-making when facing big financial decisions, such as buying cars and homes and investing your savings. You need to be aware of what makes you happy, and take this into account in making big decisions, but the decision-making itself should be rational.


3 comments:

  1. Very nice comment, makes good sense.

    As a follow-up question, to what extent would you consider the impact of OTHER PEOPLE's emotions (i.e. behavioural economics) in your plans?

    Also, the current introspection I'm going through is to what extent should one's perspective on long-term trends - possible/likely decline of US economy and dollar and impact on Canadian economy - be reflected in one's personal investment strategies. The emotional aspects - loss aversion, confirmation bias, ... - play a part here too...

    The fun never ends...

    Thanks!

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  2. So you will be on Dr. Phil next week discussing Money is a Tool?

    Points well made.

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  3. @Fernando: I'm very interested in behavioural economics, but mostly from the point of view of trying to avoid cognitive errors myself and trying to help others avoid them. When it comes to investing, I count on the existence of a risk premium that comes from people discounting the future too much, but I don't try to rely on any other biases. Many other formerly exploitable biases that create market inefficiencies seem to have gone away over the last couple of decades. I don't want to get caught trying to exploit some inefficiency after others have begun trying to do the same thing.

    @Big Cajun Man: The big difference between me and Dr. Phil is that I'm not primarily interested in trying to get people to cry on camera.

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