|There are several reasons this happens even to the best of us. For one thing, sometimes it is just too difficult to see the forest for the trees. There is so much going on these days — so many factors impacting so many chain reactions — no wonder it is hard to keep focused on more than one thing. This is why it is easy to get preoccupied with, let’s say, sovereign debt problems in Europe, and miss following how far the domino effect may actually reach. I know, I know; if I had a dollar for every time someone called me a “permabear”…but if I could ignore how all the trees in the forest are pointing towards another recessionary round, I would. I really would.Anyway, thankfully, there are small consolations. Empirical research shows that people who tend to make structured decisions tend to act less emotionally. For example, investors who invest in default plans, such as payroll investment plans or who sign up for automatic rebalancing of their portfolios, take the discretionary investing out of the equation and allow the positive long-term market behavior to happen organically and naturally.The emotions behind money that drive us to making irrational decisions are powerful, but they must be kept under control. Funny thing, emotions…seeking the short-term rewards instead of focusing on the long-term goals. Some people’s relationship with their portfolio could be equated to the relationship they have with their fridge. I bet that chocolate cake seemed like a great idea at the time, but those of us burdened with slow metabolism know how much that one indulgence is likely going to cost us in the long term. Oddly, it appears that the difference between emotional eating and emotional investing lies in the fact that the former might be easier to control.How do we fight emotional investing? First, investors must understand that emotions are ephemeral and short-lived and they easily switch gears. Which is why waiting a few days often leads to making better, more financially prudent, long-term decisions. Also, consulting with an expert or someone you trust, showing them your due diligence research, and putting the two heads together to arrive at a rational decision is often the best thing you can do about your
Finally, stick to simple products when making investment decisions. If you do not understand an investment, a strategy or a product, stay away from it. Credit default swaps (CDS’) are a textbook example of a complex product that has driven many sophisticated investors into making decisions that are too simplistic. They did not understand CDS’ or the risks involved, but invested their clients in them anyway.
Perhaps all of the “smartest guys in the room” thought it would have been embarrassing not to get in on a deal that looked like a no-brainer moneymaker just because they could not understand a single thing about CDS’. Perhaps they understood CDS’ well enough, but chose to ignore the risks simply because it was the easier thing to do. Regardless, decisions made were not based on critical reasoning, but on emotions, and we all know how that ended up.