In his new book, Finance for Normal People: How Investors and Markets Behave, Professor Statman dismisses the popular idea that investors should set aside their emotions. By embracing their emotions, he argues, they can actually learn from their mistakes. His books is a follow-up of sorts to his 2011 one, What Investors Really Want, and it builds on work he has published on the topic in numerous research papers and articles.

Emotion has its place

As the field of behavioral finance has evolved, so has the lens its practitioners use to view investor behavior.

“In the early days, we talked too much about people who are irrational and too little about people who are just normal—and usually normal is smart,” Professor Statman told In The Vanguard. “If we recognize the errors we make, we can overcome those errors, both cognitive and emotional.”

Emotions can play both a positive and negative role in investors’ decisions.

“It’s very common, when people talk about behavioral finance, to think of emotions as a synonym for emotional errors,” he said. “But the usual advice to set emotions aside when you invest is neither feasible nor wise. Fear is a very useful emotion. When people fall for scams, it is because they did not fear enough.

“Emotions are usually good teachers. For example, regret over a mistake we’ve made teaches us not to make it again. But emotions can sometimes mislead us. If you invest in stocks and the market goes down, you’ll feel regret, but you’ll need to pause and ask yourself whether you truly made a mistake. Just because the market went down doesn’t mean you should dump all your stocks and put your money in Treasury bills.”

Control what you can

Stocks have surged since the U.S. presidential election, defying analysts’ initial expectations. The surge, Professor Statman said, offers investors a lesson on the perils of hindsight.

“Hindsight can be useful, and it can also be dangerous,” he said. “I don’t tell myself that I knew the market would go up, because, in truth, I did not know. And I don’t know where the market is going next. I keep my portfolio allocation steady according to the risk I can sustain, and I don’t try to predict what the market will do next.”

Behavioral finance can be useful in creating a long-term investment plan. Determining your goals is the first step.

“It comes back to what it is you want,” Professor Statman said. “Set the allocation of stocks, bonds, and other investments so that you have a portfolio balance that’s consistent with the balance of your goals. And make sure you’re knowledgeable about investments and markets”—and knowledgeable about yourself, too.

Notes:

All investing is subject to risk, including the possible loss of the money you invest.

Opinions expressed by Professor Statman are not necessarily those of Vanguard.