Why emotional investors drive markets – but reason usually prevails in the end

 
Greg B Davies
We need to feel comforted in the decisions we make

Like the age-old debate of nature versus nurture, the question of whether markets are driven by emotion or reason elicits the age-old answer: a bit of both.

In the long run, markets are driven by all sorts of non-emotional economic and political factors, such as GDP growth, productivity, political stability and all the things that govern the ability of companies to produce profits, and therefore dividends for investors. But, of course, in the long run, we’re all dead!

Markets consist of people making decisions. Most of these people will like to think that their decisions are driven by reason. As humans, our investment objectives are typically about growing wealth over the long term, so you may think that we could simply align our decision-making with long-term drivers, and eliminate the role of emotion in driving both markets and our investing decisions. Unfortunately, we don’t live in the long term. Every single decision we make in life, we make now – in the present. And in the present, all sorts of gut feelings and emotions influence even our most-reasoned decisions.

In the uncertain world of investing, it is often very unclear what the “right” decision is, no matter how much reason we deploy. As a result, there always comes a moment when our reason has done everything it can. And even before that point, the decisions we make serve a second objective: our need to feel comfortable enough with this decision to carry it out, and then to stick with it through the often-turbulent ride ahead. Some portion of every choice we make is devoted not to the objectives we think we’re trying to achieve, but to assuage our need to feel comfortable with our decisions when we make them.

People do what feels comfortable, even if it conflicts with what is reasonable. We get comfort from many places: buying familiar assets, or investing in things we’ve read about; buying into good stories, or star investment managers. We get comfort from not being alone; from knowing that friends are invested in the same assets. In bad times, we acquire comfort by selling when we’re fearful; when the media are full of bad stories; and when the world feels dangerous. As Daniel Kahneman, the father of behavioural economics, notes: “nothing in life is as important as you think it is, while you’re thinking about it.” Investment decisions, in other words, are made by emotional people, who think they’re being reasonable at the time.

When we take all these decisions together, it is clear that, at any point, markets are a reflection of our collective emotional state and our immediate need for comfort. They will, over short periods, respond to the dominant emotional state of market participants. When the immediate surroundings feel good, collective emotional security comes from following the herd, so investors make bolder decisions. When the immediate surroundings feel gloomy, emotional comfort is more likely to come from postponing investment decisions or investing less.

Our emotional state can fluctuate much more rapidly than the long-term prospects for the economy, and this is reflected in how unstable markets can be from day to day, particularly when events lead us to focus more keenly on the immediate present than on the distant future.

These short-term emotional needs can push whole markets a considerable distance away from the sort of valuation that would arise from pure reason. Since we cannot know the future, it is exceptionally difficult to cleanly judge what the “right” market valuation is. So given a large range of possible answers, we reach for the one that feels most emotionally secure. And humans have a phenomenal capacity to construct complex “reasoned” justifications for what they feel to be intuitively right – and then convince themselves that they arrived at comfort by reasoned argument, rather than that they arrived at the reasoned argument to justify a gut feel. We have only to look back at the This-Time-its-Different arguments – some of which were highly sophisticated in complexity, if not veracity – forwarded at the peak of the internet bubble to justify investors’ deep emotional need to believe that the astronomic valuations were reasonable.

But in the end, humanity can’t prop up a market (or keep it in the doldrums) through sheer force of emotional will. Sooner or later, economic and political reality will intervene, and less emotional, more reasonable, participants will start betting against the herd, seeding a change in the predominant emotional state of the market. Suddenly, an element of doubt colours what felt comfortable to most market participants, and markets will swing back towards something more dictated by reason.

So, are markets dictated by emotion or reason? In the end, they fluctuate in the short term according to predominant emotions – but over the long term, emotion will always be tempered by reality, and by reason. This said, whatever approach you take to investments, they can still fall in value and you may get back less than you invest.

Greg B Davies is head of behavioural and quantitative investment philosophy at Barclays. He debated this subject at the City of London Festival, broadcast on BBC Radio 3 tonight at 10pm.