A Look Inside the Investor's Brain

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With this being the start of a new year, it's a fitting time to take your emotional temperature as an investor. Whether you are running hot or ebbing cold, the fact is that successful investing requires you to use your emotions intelligently -- and that, I'm afraid, is not so simple as just minding the well-publicized bogeymen Fear and Greed.

Behavioral Finance and why you should learn to love it
The field of behavioral finance marries human behavioral psychology with the study of market phenomena, with much to say about how emotions can foul or, alternatively, boost your returns. Two individuals whose work in this area is both accessible and revealing are money manager Ken Fisher and Dr. Meir Statman, professor of finance at the Leavey School of Business. Their findings and insight can benefit all Fools, regardless of investing style or risk tolerance.

Surprise! You actually need those darned emotions
Notice, above, that I referred to investors using their emotions, not shutting them off. Statman argues that emotions enable investors to identify choices and their potential consequences and, subsequently, to act on those choices.

For example, stock picking based on reason alone can lead to a long list of value plays. Fear of the cheap becoming cheaper, however, can prompt an investor to average into positions by buying in thirds, or to stay on the sidelines altogether. Such an approach would have helped mitigate the pain for those investors who were interested in the likes of Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , Goldman Sachs (NYSE: GS  ) , and even "toll-road" operator Visa (NYSE: V  ) following their initial, but far from ultimate, drops. Additionally, a healthy dose of the willies might be just what's needed to precipitate an extra round of due diligence.

That, of course, is the rosy scenario. In his book The Only Three Questions That Count, Fisher offers advice for when emotions slam your returns to the mat.

Of Pride and Regret
Investors hate losses. In fact, studies have shown that losses hurt about two and a half times as much as gains feel good. Furthermore, investors go through all sorts of mental machinations to avoid experiencing the pain of loss, a behavior termed loss aversion.

Loss-averse thinking takes many forms: I'm only down on paper, the stock will go back up. Or, Nah, it's fine, I can sell and use the loss to offset my taxable gains. And don't forget the desperate, I'm not even opening my brokerage statements for the next three quarters!

Fisher suggests that loss aversion is explained by the related mental processes of accumulating pride and shunning regret, evolutionary holdovers from our days as Stone Age hunter-gatherers. Such a hunter, Fisher describes, accumulated the emotional asset of pride with each successful foray and, with a smiling tribe at his back, was thus motivated to risk life and limb on future kills. Moreover, in the hunter's mind, his success was due to skill, not luck, which meant that he could do it again.

Conversely, on the days that the fanged, hoofed, and horned beasts were just too quick or wily, our empty-handed chap preserved his predatory mojo by blaming the loss on circumstances outside of personal control, say, evil spirits in the canyon. Image and ego intact, he could face the demands of the hunt on a new day.

While shunning regret and accumulating pride were essential psychic mechanisms 25,000 years ago, Fisher argues that they now work to the detriment of the contemporary investor.

How many times have you held rocket stocks too long, avoiding the regret that would surely lay you low if you sold too soon? I committed that error in 2008 with highfliers Suntech Power (NYSE: STP  ) , BHP Billiton (NYSE: BHP  ) , and Freeport McMoRan (NYSE: FCX  ) .

Now, I recognized that I was insufficiently prescient to identify a top in the solar and commodity booms. Good for me, but here's the truth: I was still in the black when I perceived the extent of the likely collapse in all three stocks. But take a puny gain against what was very recently a triple-digit profit? I couldn't do it. I shunned the regret that would accompany cashing out, and in so doing, paved the way to deep double-digit losses.

Brain Rehab 101
Most of us have been there. The key is to sidestep repeat performances. Among the strategies that Fisher offers, two stand out. The first is to constantly, suspiciously, and dogmatically ask yourself the following questions: What is your brain doing to make you run amok? What emotions are at work in your investment decisions? Are they guiding you toward appropriate due diligence or wrapping your ego in lamb's wool at the expense of your net worth?

Second, Fisher advocates turning Stone Age psychology on its skull: accumulate regret and shun pride. Every time you make a successful investment, inquire how your thesis could have been wrong. As for mistakes, embrace them: Keep a record both of what you thought led you astray, and what you felt about the mistake. I know, when you really botch up an investment it feels like even the family dog knows about your buffoonery. Look Fido in the eye and remind him, and yourself, that if you are wrong 30% of the time, you're still an All-Star.

Finally, and this is from Statman, doing nothing is usually a more tempting alternative to action because it carries less risk of regret: whatever is going to happen will happen because of the market, not because of what you did.

If the current mayhem has this sounding like a choice between two bad alternatives, you can seek shelter in David and Tom Gardner's Motley Fool Stock Advisor service, where you'll get buy and sell advice on stocks and can interact with thousands of your fellow Foolish investors. Click here for more info.

Fool contributor Mike Pienciak is fairly calm at the moment. He owns shares of Suntech Power, Freeport McMoRan, and BHP Billiton. JPMorgan Chase and Bank of America are Motley Fool Income Investor picks. Suntech Power Holdings is a Motley Fool Rule Breakers recommendation. The Fool is investors writing for investors.

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