IN STOCK investment, it is said that all of us are driven by two emotions: greed and fear. Often, we wish we could be perfectly rational in our decision making. But the fact is, we would have a very hard time making choices if emotions did not come into play.
Neuroscientist Antonio Damasio studied people who had damaged the part of the brain where emotions are generated. In all other respects, they seemed normal; they just lost the ability to feel emotions.
Damasio found that the decision-making ability of this group of people was seriously impaired. They could logically describe what they should be doing. But in practice, they found it very difficult to make decisions about where to live, what to eat and so on.
In truth, many decisions have pros and cons. Shall I have the fish or the beef? With no rational way to decide, people who cannot feel any emotion are unable to make any decisions.
Riskier options
In another study, Bechara et al examined the decision making of patients with lesions in their pre-frontal cortex - an area that integrates emotion with cognition. They compared patients' performance on a test known as the Bechara Gambling Task to an optimal strategy that maximised expected value. The patients consistently chose riskier options that failed to maximise expected value, and they also exhibited lower levels of galvanic skin conductance in response to risky choices.
The patients' diminished skin conductance was used to argue the idea that patients lacked emotional responses to the risky choices, and that emotions can be a necessary cue for making normatively rational decisions.
So emotions are essential in decision making - and, in fact, necessary for us to make rational decisions.
On the other hand, studies have also shown that different emotions can affect people's decision making in a discernible pattern. So being aware of our emotional state at the point of decision making, of how that emotion tends to bias our decisions, will hopefully lead to fewer errors in judgement.
Broadly, emotions come into a decision-making process in two ways. First, in trying to make a choice, we try to envisage the emotions we will experience when the outcomes materialise. For example, in deciding whether to invest in a high-risk and high-return commercial development project, a potential investor might attempt to predict whether she will feel regret (or relief) if she did not invest in the project and it yielded huge returns (or losses). This is referred to as expected emotions.
A decision-maker will try to select an action that maximises the net balance of future positive to negative emotions.
However, a decision based purely on expected emotions is not effective, as people systematically mispredict their reactions to outcomes of their own decisions. For example, someone might think that she would be very happy if she accepts a more responsible position and receives higher pay. But when she takes the job, she could find that she misses the free time and less stressful days she used to have and hence is not much happier than before.
Ethical reasons
Besides, expected emotions may not include, say, the economic, practical or ethical reasons - factors that the decision maker should care about - in trying to choose a particular course of action over another.
The second type of emotions which come into play during decision making are called immediate emotions. These are real emotions experienced at the time of decision making.
Immediate emotions fall into one of two categories: anticipatory influences and incidental influences. Anticipatory or integral influences are the influences from immediate emotions that arise from contemplating the consequences of the decision itself. For example, while thinking about possible consequences of investing in a risky project, the investor might experience immediate anxiety at the thought of the project failing.
Integral emotions are relatively insensitive to probabilities and are especially sensitive to the timing and vividness of the outcomes. As an event approaches in time, or increases in vividness, integral emotions such as fear tend to intensify. This leads some people to pay more for insurance protecting against death due to terrorism than for insurance protecting them from other causes, and leads people to be afraid of flying but not driving even if objective risks are far greater for the latter.
Integral emotions have both good and bad influences on decision making.
On the one hand, they often crowd out considerations of expected emotions and cause people to make decisions that ignore or underweight important future consequences. An example would be people who put off going to a doctor to check a symptom for fear of knowing the results when an early cure may mean a difference between life and death.
On the other hand, integral emotions do provide intangible but important inputs for decision making as well as impetus to execute the decision.
Finally, incidental emotions are immediate emotions that arise from factors unrelated to the decision at hand. For example, if the weather is sunny or a happy song is playing on the radio, the undecided investor might experience incidental happiness at the time she contemplates her choice. And happy people generally demonstrate less depth in processing the information available and are prone to taking more risks as well.
Numerous studies have revealed powerful effects of incidental emotions on decision making. Hence being aware of our emotional states and the possibility that they are a potential source of biased choice and reckless action will be useful.
Here are some findings of how different emotions affect our decisions:
- People tend to be more optimistic when they are in a good mood than when they are in a bad mood.
- Anxiety or fear is associated with uncertainty and lack of individual control, and hence affects people's judgment of risk. So anxious people make relatively pessimistic and risk-averse choices.
- Sad people tend to choose an option that maximises rewards.
- Angry people make relatively optimistic and risk-seeking choices.
- The choices of angry individuals more closely resemble those of happy individuals than those of fearful or anxious individuals.
Incidental emotions also affect other kinds of decisions, such as valuation of objects.
Disgust and sadness
Disgust has been shown to reduce, while sadness increases, buying prices of an object. For disgusted people, the act of buying represents a potential source of contamination whereas, for sad people, buying represents an opportunity to change the circumstances (by acquiring new goods). For example, investors hit once by poor governance of Chinese companies will only be enticed to buy Chinese stocks at very low prices.
On the other hand, disgust and sadness would decrease selling prices. An investor, disgusted by a company's management for misleading investors, will dump the stock at any price. For sad people, it's an opportunity to change the circumstances.
Meanwhile incidental happiness induced by finding a 50-cent coin in the phone booth or receiving free cookies increases people's willingness to help others. Similarly, incidental gratitude also increases people's willingness to engage in costly helping behaviour.
Seunghee Han and Jennifer Lerner of Carnegie Mellon University noted in their paper titled Decision Making: 'Considering that these effects all held, even when real outcomes were at stake, these studies demonstrate reliable and non-negligible effects of incidental emotions. Fleeting feelings from one's past can systematically alter decisions in the present.'
So beware.
The writer is a CFA charterholder. She can be reached at hooiling@sph.com.sg
