How to take fear out of your investing decisions

  • By Daren Fonda,
  • Barron's
  • Economic Insight
  • Investing Strategies
  • Economic Insight
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When fear grips the stock market, it's good business for Denise Shull. A Wall Street "performance coach" with a background in neuroscience, Shull helps investors delve into the emotions underlying their decisions. Her phone has been ringing lately. A portfolio manager in Asia "wanted to figure out what he should do with his frustration," she says. He was asking, 'Should I react to this market action or stick with my long-term conviction?' "

Fund managers aren't the only ones trying to curb their emotions these days. The market's 6.9% slide in October and the stock averages' wild swings are testing everyone's mettle. Sure, you think you're tough as steel, immune to emotion-driven buying or selling. But neuroscientists and behavioral economists argue that biases are hard-wired into our brains and personalities: Some of us are overconfident, taking excessive risks; others too meek, seeking to avoid losses at the first sign of trouble. We're also biologically programmed to look for patterns in unrelated information—seeing the face of Jesus in a piece of toast, or a cloud with an uncanny resemblance to Abraham Lincoln.

Erasing this wiring isn't possible, according to a growing body of research. And there's a growing recognition that it's better to manage behavioral biases than to ignore or suppress them. Investment firms are hiring coaches like Shull to understand how emotions influence investment decisions. They're also using machine-learning software to analyze historical returns and trading patterns to see if managers are falling into common behavioral-finance traps.

"What neuroscience has confirmed is that it's impossible to make a choice without emotions," says Mike Ervolini, CEO of Cabot Investment Technology, a Boston-based firm that sells behavioral-finance software to institutional clients. That software has analyzed more than $3 trillion in client portfolios worldwide, he says. In 80% of the cases, it has found at least one persistent behavioral tendency that costs the portfolio more than one percentage point annually in returns, relative to what it would have earned optimally.

Some mistakes, he says, arise from the tendency to feel pain from a loss more acutely than pleasure from a gain. Investors sell too quickly when holdings take a few hits, and hesitate to build big positions in stocks they like. They hold winners too long, because they overvalue them. "Managers tend to buy a stock, and it does really well for 12 to 18 months," he adds, "but then they hold for another six months, and it becomes dead money."

It's one thing to be aware of behavioral biases; it's another to keep them in check. Advisors use risk-tolerance questionnaires to see how much pain a client can take in exchange for potentially superior returns. But "as Mike Tyson used to say, 'Everyone has a plan until they get punched in the face,' " says Jay Schechter, a partner with Singer Xenos Wealth Management in Coral Gables, Fla., who's playing the role of therapist for his clients these days.

But advisors, like doctors, can't help anyone unless they accept good medicine. That's where "psychometric" software can play a role. Syntoniq, a start-up near Los Angeles, sells an online tool to help advisors psychologically profile clients. An investor would see an image of a Fijian tribesman pointing a spear at a charging wild boar and be asked to rate the tribesman on a scale from "very likely to be peaceful" to "very likely to be aggressive." The idea is to assess perceptions of risk, financial literacy, confidence, and other factors, so that portfolios reflect clients' goals and psychology, says Prasad Ramani, Syntoniq's founder and CEO. "The way to change behaviors is to increase self-awareness about blind spots and behavioral biases," he says.

While investors might think panic selling is rampant when the Dow (.DJI) tumbles 800 points in one day, for instance, only 0.35% of outstanding U.S. equity shares trade on an average day, and even on a volatile one, just 0.6% change hands, notes Jason Voss, a former portfolio manager and author of The Intuitive Investor. Rather than be swayed by big market moves, Voss says, investors should take a timeout between the "stimulus" and response, even if just to meditate for 15 minutes—something he recommends.

So, should you put your investments on 10-year autopilot? Long-term buy-and-hold investors shouldn't change their asset mix based on a few bad days or a correction (a drop of 10% or more). Schechter shows worried clients that trading is often counterproductive; from 1995 to 2015, he points out, investors earned about half of the market's return, on average, due to "greed and fear," or buying high and selling low.

Nonetheless, this may be an opportune time to trim equity risk. The economy is in the late stages of a recovery, valuations are high, and after years of gains, investors may be sitting on too much stock exposure relative to fixed-income holdings, says Campbell Harvey, a professor of international business at Duke University's Fuqua School of Business. A consultant to investment-research firm Research Affiliates, he recommends adding quality and value shares (or exchange-traded funds that hold them), because they should be less susceptible to losses in a correction.

However you invest, he advises, realize that most of the market's signals—technical moves, trading patterns, and the like—are just statistical noise. "People yearn for an explanation for stuff that's often impossible to explain," he says. What you think is a pattern in the market, in other words, may be as random as seeing Abe Lincoln in a cloud.

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