Emotional Intelligence and Investor Behavior

Forward (CFA Laurence B. Siegel)

Does it really help investment performance to be able to keep your head when all about you are losing theirs?1 Logic suggests that the answer is “yes” because booms are followed by busts, which are followed, in turn, by new booms. (This cycle seems to exist at the industry and security level as well as at the market index level.) Investors who can trade against this cycle of emotion—buying when others are panicking and selling when others are basking in their new found fortune—should be able to beat the market index. This question seems particularly timely as I write this foreword in December 2008. The S&P 500 Index has fallen 52 percent from peak to trough and as much as 8.8 percent in one day. Outside the United States, many markets have fallen even farther. Is it time to buy? Before responding, “Of course, it is,” the reader should consider the following questions:

• Buy how much? Just enough to rebalance to a preset asset mix? Or more?
• How quickly? Should one “average in” to the new target? Or reallocate all at once?
• If you are wrong and the market falls another 20 percent, should you then sell?

Or should you buy even more? Investors who take what my friend and frequent co-author Barton Waring calls a “clear-eyed, hard-headed” view of markets may not have much trouble with these questions, but such investors are few. Most investors have difficulty overcoming fear when prices are falling, so they buy too little; then, they become subject to greed when prices are rising and sell too little or hold too long. The advantage of being able to manage one’s emotions productively is not confined to such market timing. Emotionally laden decisions include how much active management to use, how frequently to trade, how concentrated one’s portfolio should be, how extensively to use risky or novel strategies, and—perhaps most importantly—how much to save and invest (as opposed to consuming). Anyway, we should not be satisfied with our (admittedly sensible-sounding) guess that investors who can manage their emotions might perform all of these tasks better than those who are overpowered by their emotional reactions. We want data! In Emotional Intelligence and Investor Behavior, John Ameriks, Tanja Wranik, and Peter Salovey provide exactly that. Having conducted a survey of Vanguard IRA and 401(k) investors, the authors show that investors who score highly on tests of “emotional intelligence” (EI) tend to exhibit behaviors (e.g., the use of low-costfund options, a decision not to trade too frequently) that correlate strongly with good investment performance.

EI is something quite different from being emotional or being in touch with one’s emotions. It is defined by the authors as the ability “to recognize and use emotions productively.” Thus, in some situations, being emotional may pay off; in others, being coolly dispassionate will garner rewards. Either type of response could be defined as emotionally intelligent because the criterion is whether the response is productive (that is, has a positive payoff).

The idea that there is more than one kind of intelligence (not just IQ or some other general measure) dates back at least to the work of Howard Gardner, who, in a celebrated 1983 book, identified a constellation of “intelligences”—including logical, linguistic, bodily, musical, interpersonal, and so forth.3 The psychologist Peter Salovey, one of the co-authors of this work, is noted for developing the idea of, and devising tests of, EI, which is a concept closely related to Gardner’s interpersonal intelligence.4 Salovey and his colleagues have conducted their research on EI in multiple settings and demonstrated that it plays a significant role in positive social relationships, health, and well-being. In a chapter entitled “Applied Emotional Intelligence: Regulating Emotions to Become Healthy, Wealthy, and Wise” in Salovey (2001), the author suggested that EI should also play an important role in financial decision making. Similarly, Charles Ellis, a financial expert and author of several books, is convinced that because emotions are rampant in the domain of financial decision making, those who are emotionally intelligent should be better investors. Inspired by these ideas, financial economist John Ameriks and psychologist Tanja Wranik set out to test them empirically. We are very pleased to present the fruits of this interdisciplinary effort.

Click Here To Read: Emotional Intelligence and Investor Behavior

About Miguel Barbosa

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04. February 2010 by Miguel Barbosa
Categories: Behavioral Economics, Curated Readings | Leave a comment

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