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17 November 2016 Multimedia

How Emotions Undermine Our Investment Decision Making

  1. Frank Murtha

Frank Murtha, co-founder of MarketPsych, a behavioral finance consulting firm, has researched investor psychology extensively to better understand why investors often make irrational decisions. In this interview, Murtha explains how personality affects investing, how important self-awareness is, and how investors can mitigate their behavioral blind spots. He also identifies some of the common traits of successful financial advisers.

The Take 15 Series is a series of short interviews with leading practitioners on timely topics focused on the investment profession.


DAVID LARRABEE, CFA: Welcome to another Take 15 interview from CFA Institute. I'm Dave Larrabee, and I'm joined by Frank Murtha. Frank is co-founder of MarketPsych, a behavioral finance consulting firm. He's also the author of MarketPsych-- How to Overcome Fear and Build your Investor Identity. Frank, thanks for joining us today.

FRANK MURTHA: It's my pleasure.

DAVID LARRABEE: How does a person's personality affect their investment decision making?

FRANK MURTHA: Great question. A person's personality has an extremely important effect on how they go about their investing. When people talk about personality, they're usually referring to the different components that comprise it. And for lack of a better way of putting it, there's basically five. And each one of those five investor personality components, five factors, as they're often called, has a huge effect. It affects everything from your optimism versus your pessimism, what types of investment and asset classes you would prefer, and how well you deal with the emotional roller coaster that investing can become.

DAVID LARRABEE: And how important the self-awareness to the success of the average investor?

FRANK MURTHA: Self-awareness is critical. You know, when you take a look at what all the great investors have in common, there's all different types of styles and all different types of formulas for success. But something they all have in common is that they are aware of their strengths, their tendencies, their vulnerabilities. And the ability to bring them to one's consciousness is what allows us to avoid making terrible mistakes.

DAVID LARRABEE: There must be some techniques out there that are available to help us mitigate the impact of emotions on our investment decisions. What are some of those?

FRANK MURTHA: Well, I think one way to mitigate one's emotions when it comes to creeping into the process and leading us down the wrong path is to enlist the help of another individual. The ability to have somebody else hold up a mirror, to get that interplay, to get a little bit more feedback-- investing is challenging enough as it is. Attempting to do it on one's own makes it that much more challenging.

DAVID LARRABEE: Frank, you've done a lot of research on behavioral pitfalls, what are two or three of the most destructive blindspots of investors? And what can we do to avoid these or at least minimize their effect?

FRANK MURTHA: Well, you know there are certainly a number of them. One of the ones that leaps to mind is what we call "short-term framing." It's when we get stuck in a short-term framework for evaluating our portfolios and our decisions. You know, my town sent out a memo, and it said-- over the summer-- if you have any standing water in your backyard, tip it over. Don't let the standing water exist. And the reason why is because it's the breeding ground for mosquitoes. A short-term framework is a breeding ground for emotional biases.

And I look at this particular bias, the short-term narrow-framing bias, as being something like gravity. Gravity is happening all the time without our awareness. It takes a conscious effort to bring gravity into our awareness so that we can exert an effort that pulls us out of it. Otherwise, it's just going to naturally drag us down. And it's the same way with a short-term focus. We have to consciously fight against it, expand the scope, and that will enable us to have a healthier perspective, lead us to make better decisions. So the framing with a short-term focus based on what's happening in the market, oil prices, presidential elections, these are the sorts of things that draw us in, make emotions all too prevalent, and it's probably the biggest reason why investors suffer underperformance.

DAVID LARRABEE: Let's turn to the role of the financial advisor. Why is it important for a financial advisor to understand this client's financial values?

FRANK MURTHA: It's important for financial advisers to understand their client's values because those values are the fundamental most basic reasons that drive the investor behavior in the first place. You know, it's interesting, there are a lot of different plans that would work for clients. I mean, advisors can put all sorts of different asset allocation models and most of them are going to do their job for the client. But there's a critical factor-- is it a consistent fit for who that client is? That's what's going to enable the client to stay the course, to make the right decisions, and complete that plan. And understand the client's values is a critical component to that.

DAVID LARRABEE: Absolutely. So in your experience, what are some of the traits shared by the most successful financial advisors out there?

FRANK MURTHA: Well, being great listeners. If you are a great listener and a great asker of questions, then you've got two of the most important skills to be a great financial advisor. You know, as I mentioned-- well, actually haven't mentioned this, I think that a lot of clients out there don't appreciate the value that the financial advisor brings. And I think part of it is because they get caught up in a mentality that says, oh, it's all about numbers. And it's all about performance. But the fact of the matter is that's not what investing is about.

Investing is about living the life you want to live. And in order to do that, you have to really talk to somebody, understand what your goals are, understand what the investments are that are going to help you realize those goals. And when you have an advisor who understands their values, is a great listener, a great communicator, then you've got a formula for success because now you're building a relationship with that client that's going to get them where they need to get.

But I really think a lot of it boils down to helping the client understand this isn't about 10% versus an 8% benchmark, this isn't about sharp ratios and all these other numbers we use. It's about what do you want your life to look like, and I'm going to help you get there.

DAVID LARRABEE: Great. Frank, thanks very much for sharing your insights with us today. And thank you for watching.

SPEAKER 1: Copyright 2017, CFA Institute. All rights reserved. This program is designed to give accurate and authoritative information in regards to the subject matter covered. It is distributed with the understanding that CFA Institute is not engaged in rendering legal, accounting, tax, investment, or other expert advice. If legal advice or other expert assistance is required, the services of a competent professional should be sought.

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