Rational Investing

The concept of the rational investor has come under attack in recent years with the rise of neuroeconomics. It seems that we bring many biases, illusions, and other irrational thinking with us when we make investment choices. What does this make of my oft-stated belief that investors should strive to control their emotions and make rational decisions?

I’ve been told that because we now have strong evidence that investors are driven by so many emotions, my support for rational investing is passé. I don’t dispute the lessons of neuroeconomics; investors have many biases and often make emotional investing decisions.

However, just because we do make emotional choices doesn’t mean that we are best off investing this way. Even if we need to understand the emotions of others to best understand equity markets, we still do better as investors to push emotions aside and make rational choices that take into account the irrationality of others.

Studying neuroeconomics is fascinating. It gives great insight into why markets behave as they do. It also shows us what mistakes we should try to avoid. Investing rationally is the best approach.

Comments

  1. Mark WolfingerMay 9, 2011 at 9:31 AM

    It's very difficult for the naive investor to sit on the sidelines as the markets rise. At some point they have to go get their share of the 'free' money.

    When holding in a decline, it is just as difficult to accept the fact that money has already been lost. Telling themselves that it's not a loss until it is realized, they fool themselves into holding longer. Eventually they cannot stand the pain and and exit.

    Very difficult to provide advice that allows people who just don't understand to suddenly see the light.

    Regards

    ReplyDelete
  2. Michael JamesMay 9, 2011 at 10:54 AM

    @Mark: I agree that it is difficult to reach people, but I'll keep trying.

    ReplyDelete
  3. AnonymousMay 9, 2011 at 12:03 PM

    I think they should call it "psychoeconomics"

    Economics is an art not a science. In science there is usually a much greater than 50% chance your predictions will be correct.

    ReplyDelete
  4. TaraMay 10, 2011 at 6:59 PM

    I guess my investing could be considered rational - I invest the same amount every paycheck, regardless of what the market is doing. I have never pulled my money out of the market - I keep buying all the way down. I'm in it for the long haul.

    ReplyDelete
  5. Michael JamesMay 10, 2011 at 8:08 PM

    @Tara: If you're sticking to a plan through thick and thin, it sounds like you're not giving in to greed or fear.

    ReplyDelete

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