Deploying Financial Emotional Intelligence

Emotions can influence financial decisions in surprisingly predictable ways. We tend to be overconfident in our own knowledge and decisions, we extrapolate recent trends while dismissing the past, we refuse to accept losses gracefully by hanging on to our losers far too long, and so on. Even experienced investors are not immune (see Garvey and Murphy 2004).

The lengthy roster of mental pitfalls persuades us to deem our feelings and emotions mere distractions from wise financial decision making. We reasonably conclude that sound thinking requires that our emotions be fully eradicated, always and everywhere. We even pride ourselves on our ability to toss aside our emotion-laden thinking and direct our decisions with an intense, systematic focus on quantifying market insights. Such an unemotional, evidence-based approach to decision making, we claim, disciplines us to shun the harmful biases we inflict upon ourselves.

Simply conquering and restraining our unconscious, however, leaves me dissatisfied. Contrary to conventional thinking, psychology has revealed that we should not underestimate the important benefits of the unconscious and its interactive role with the conscious brain (see, e.g., Damasio 2010). Among its benefits, our best ideas and inspirations — our “Eureka moments”¹ — originate in our unconscious.² In this piece, I argue that a contemplative process whereby we allow the unconscious to inform the conscious — let’s call it financial emotional intelligence³ — offers a compelling way to improve discovery and decision making.

Battle of the Brain

Clearly, decisions made below the surface of our minds factor crucially into investor and market behavior. According to neuroeconomics research, the areas of the brain responsible for our emotional states powerfully influence how we think about risks and rewards. We frequently make what we firmly believe to be rational decisions, but those decisions are primarily based on the input of our own emotions, not ideas, data, or analysis — a common occurrence even among experts.

In one study, Levav and Argo (2010) found that participants who were lightly touched on the shoulder by a woman were willing to take greater financial risks than those who were not touched. In another study, Kuhnen and Knutson (2011) found that subjects unknowingly made less risky investment decisions after viewing a picture associated with negative affect versus those viewing neutral pictures. These and similar cognitive lapses allow algorithmic traders to take advantage of the predictable emotional responses of others.

Successful investing unambiguously places deliberate thinking — driven by rigorous factual analysis — foremost. Thus, in the mental tug-of-war that is decision making, we must press the deliberate conscious to get the upper hand. Engaging our consciousness gives rise to the ability to survey the range of possibilities and optimize decision making. The advantages of reasoning, deliberation, and planning are remarkable. We simply cannot run our lives, our portfolios, or our businesses without deliberate thinking.

Giving precedence to robust reflection, however, does not necessarily render useless our intuition and emotions. On the contrary, intuition and emotions are an indispensible part of the ongoing struggle for optimal decision making and, more importantly, learning and discovery. To understand why, consider that conscious thinking requires emotions, feelings, and intuition. Unconsciously, our emotions allow us to identify ideas and thoughts as good, bad, or indifferent. People with brain damage in the areas of the brain that process emotion are incapable of making rational decisions, even though the parts of the brain responsible for reasoning are fully intact (see Damasio 1994). Without our emotional circuitry, we would be unable to evaluate the relative merits of alternatives, leaving us helplessly indecisive. Nor would we have the immense gratification of our Eureka moments, of feeling pleasure when we have made a wise, consequential decision. Moreover, an unemotional bad decision provides us no lift, no incentive to improve our decision making in the future. There is no doubt that emotions improve the quality of our decisions.

All of this is to say that our unconscious drives our learning, problem solving, and idea generation. Although the self-control of consciousness gives us the growth of knowledge, feelings and emotions drive that growth. Cognitive thought processes, such as the ability to weigh the benefits and costs of decisions, are thus not purely scientific. Our feelings and emotions represent information, and we have the ability to use that information wisely.

Put differently, decisions — and, more importantly, learning and idea generation — cannot be geared solely to a utilitarian approach based on pragmatic criteria. As Eureka moments aptly show, growth in learning often takes place in the unconscious, intuitive part of the brain. Thus, even complex decisions depend on our experience. Thinking is a process, not an isolated event governed by a simple consciousness/unconsciousness dichotomy.

That intuition figures prominently in our decision making is further supported by a growing body of psychology literature that shows that unconscious processes are far more capable of reasoning out optimal choices than they are usually given credit for. Experiments have demonstrated that people put in certain complex situations are able to make superior decisions by using their intuitive gut feelings rather than deliberate thinking (see Dijksterhuis, Bos, Nordgren, and van Baaren 2006; Persaud, McLeod, and Cowey 2007; Mikels, Maglio, Reed, and Kaplowitz 2011). Our properly trained unconscious can apparently enhance the quality of our decisions, not simply muddle our judgment.

How do this theory and its corroborative evidence intersect with investing? For one, they offer support for investors who seek to combine a systematic, quantitative (deliberate) approach with a looser, qualitative (intuitive) one. Such a rich, integrated process explores the full range of possibilities, going beyond a restricted view informed solely by what has happened historically. The best of ourselves requires a disciplined approach to investing but also allows for the flexibility to rely on intuition to tell us when changes are needed. Such integration could offer the best chance for performance success — say, in recognizing when a global paradigm shift is upon us (see Li and Sullivan 2011). In this way, our intuition can serve as a well-suited guide in navigating the so-called unknown unknowns, which continue to elude our systematic market models.

For example, consider how Warren Buffett has reportedly noted that investors are better served by being fearful when others are ebullient and ebullient when others are fearful. He and other successful investors have come to understand the benefits of integrating emotions (their own and the public’s) with systematic thinking (based on their valuation methods). Contrary to the cry to dispense with feelings and emotions, thinking influenced by both deliberation and emotions produces the desired outcome.

The importance of feelings and intuition also extends to moral considerations. Think about our decisions concerning ethical behavior, which is learned over time by the training of our unconscious by our conscious. We even understand solutions to complex issues intuitively. For instance, we have learned — and know intuitively — that proper ethics requires us to place the interests of the client ahead of the interests of the firm. This decision to place stewardship first may run counter to what is an otherwise calculated, optimal decision to maximize firm profits. But choosing clients over business becomes second nature, as do many other ethical considerations. There is no need to rack our brains with conscious deliberation.

A final, important point is that making decisions with unconscious guidance can free our conscious brain for such creative uses as planning and the development of new ideas.

I trust that you are now convinced that intuition and emotions can indeed be used intelligently to complement and enrich our thinking. Again, this conclusion does not mean that we should allow our unconscious full sway in our decision making. We should always stop to reflect carefully on what the unconscious is offering us, informationally. After reexamining the data, we may conclude that our initial choice is not the best one. Taking the time to check our decision against the facts and how our unconscious bears on that decision is essential.

Financial Emotional Intelligence

The main feature of financial emotional intelligence (FEI) is to bring together our intuitive and deliberate decision-making processes. It is substantially directed at aligning the workings of our conscious and unconscious — by being consciously aware of how our unconscious is affecting our decision making. This integration allows us to make better choices, enhance our wisdom and inspiration, and avoid the errors that so many of us commit. Even more compelling is that FEI can be much more than merely educating our unconscious to bring our thinking forward to our conscious mind: It is about using our intuition for inspiration and wisdom, which means taking the time to reflect on our choices, ponder the evidence, and consider how our decisions will affect our emotional state. FEI is a skill worth developing, a gift that we are uniquely able to give to ourselves.⁴

The will of our conscious can provide us with a state of mind that enables us to be the orchestra conductor who assembles our various thoughts (instruments) and coordinates their flow into productive decisions (music). Through FEI, we can engage our conscious mind to monitor the operations of other parts of our brain. Instead of repressing our emotions and intuition, FEI brings them into our reflective thinking — that is, we can require our conscious and unconscious to coexist in a way that elevates decision making to a new level. Thus, the key to successful FEI lies in our ability to channel our emotions into more productive outcomes, not simply relegate them to the dustbin.

On this basis, we can steer our behavior and decisions within the ongoing conflicts of ethics and other informed investment decisions. The conscious will of FEI is the facilitator, enabled by the process of practice and training ourselves to check our thinking against well-known biases that so often impede our decision making. Although we must never allow our investment decisions to be dominated by our emotions, we must realize that FEI takes us beyond that concern by providing the counterpunch that is far more useful than the empty will to deny our emotions.

In my former role of portfolio manager, I kept a detailed registry of each of my trades along with a note indicating the basis for and rationale behind them; comments like “purchase triggered by valuation model on market downdraft” tagged each trade along with other details, such as price, number of shares, and so on. I regularly looked back over past decisions and learned from my mistakes. I found this to be a great way to improve decision quality. I now know that there was something important missing from my trade registry — documentation on how I felt at the time of each trade. Such emotional information, entered objectively, would have given me additional input as to how my emotions correlated with my decisions. Reviewing this information would have offered important clues about how my emotions were affecting (or not affecting) my decision making and thus would have allowed me to improve on future decisions.

In implementing FEI, investors might begin by adding emotional details to their trade registry. They could improve further by checking their thinking against a list of documented, typical, negative investment behaviors and then actively seeking to minimize any negative impact. The use of such mental cues could help create an association between the cue and the behavior. A heightened awareness can serve to inform our conscious mind that an automatic mental response has been triggered that might lead to bad, unintended consequences. From there, we can refocus our brain to work toward a better-informed decision.

For example, many long-term investors reacted fearfully to the recent financial crisis by purchasing portfolio “tail risk” insurance. With a self-awareness of the true source of our reaction (fear), we can take a moment to reflect with a more careful analysis in hand. In doing so, we find that, contrary to our emotion-driven evaluation, a long-term investor is far better served by selling tail risk insurance (see Litterman 2011). Careful reflection overturns raw emotions, leading the investor to adopt an appropriate, if risky, action.

The Best of Both (Brain) Worlds

In attempting to battle the destructive impulses of our unconscious emotions, we insist on a utilitarian approach to decision making based solely on unemotional, pragmatic criteria. In doing so, however, we are not operating at our highest level.

The ongoing mental battle that underlies the quality of our choices is more complicated than it might at first appear. Although no single approach to decision making is perfect, psychology tells us that the conscious mind can be trained to tap the unconscious mind in decision making and, more importantly, idea generation. Thus, intuition, feelings, and emotions can be used to increase the likelihood of successful choices in resolving not only simple problems but also complex issues, including moral dilemmas. So, instead of repressing our emotions, we can use them for the purpose of learning, inspiration, and decision making — that is, by deploying financial emotional intelligence. Striking the right balance between deliberate thinking and emotional thinking gives us the best of both worlds, and the lengthy roster of behavioral pitfalls provides the clarion call for doing it.

This article originally appeared in the November/December 2011 issue of Financial Analysts Journal.

¹ While taking a bath, Archimedes is said to have cried “Eureka!” (I have found it!) upon suddenly discovering a way to ascertain the amount of gold in King Hiero’s crown.

² A note on terminology: I use the terms unconscious, intuitive, and emotional thinking interchangeably. Likewise, I use the opposite terms conscious, reflective, and deliberate thinking interchangeably. The literature makes little distinction between these terms. I point the interested reader to several useful references for more detail.

³ Emotional intelligence is a psychological characteristic that describes how effectively an individual identifies, understands, and regulates emotions and then uses them in problem solving and decision making (Salovey and Mayer 1990). I extend this term to define financial emotional intelligence as a person’s ability to recognize and interpret emotions related to financial situations and to use and integrate those emotions productively for optimal financial reasoning and problem solving.

⁴ Ameriks, Wranik, and Salovey (2009) found that investors with a high degree of emotional intelligence are more likely to invest wisely by trading less frequently and using low-cost fund options.