Learning about how our emotions affect our decisions is the key to understanding investing.

The interview transcript below, with behavioral finance expert Hersh Shefrin, explains more.

Professor Hersh Shefrin is from the Department of Finance of the Leavey School of Business at Santa Clara University.  He is a pioneer in the world of behavioral finance who has published a number of books, one of which is called Beyond Greed and Fear. 


I interviewed Hersh Shefrin a few months ago on the Goldstein on Gelt show. Read the transcript of the interview below. To see a video of this interview, go to the middle of this page.

Douglas Goldstein:    What role does fear play in people’s financial decisions?

Hersh Shefrin:           Fear is a primary emotion, and emotions are the elements in our brain structure that motivate us to actually do something to move.  Fear is a process within our brains.  We know how it feels like to be fearful, but it’s a process that alerts us that there’s a threat and induces us to begin the action of averting that threat.  Fight or flight is a primary response to the emotion of fear where we have to make a decision how to protect ourselves.

Douglas Goldstein:    Is the fear that you’re talking about different in terms of the fear of losing your money compared to the fear of getting perhaps eaten by a lion, where fight or flight would be more of an appropriate response?

 Hersh Shefrin:           I think our brains are not clear differentiators.  Of course, the outcome of the fear of getting eaten by a lion is, I think, so much greater than the fear of losing our wealth.  The amazing thing is that because the mechanism is so good, it varies by degree.  Losing money, especially if it’s a lot of money, can really feel terrible.  Losing face can feel terrible.  For example, we all know that in certain cultures, losing face is strong enough to induce people to commit suicide as the pain is so powerful.  Do ourselves in if the lion doesn’t do us in, but it’s a very, very strong emotion that in general is designed to help protect us from potential threats by inducing us to take action.

Fear(95769)Credit: Image: David Castillo Dominici / FreeDigitalPhotos.net


Douglas Goldstein:    What is the behavioral finance feeling that would allow someone to be so irrational?


Hersh Shefrin:           There are actually many things involved, so the first thing is a lack of self-control.  Lack of self-control typically comes from imperfect foresight.  There’s our future self and our current self, and there’s not exactly a democracy because our current selves hold many more votes and have much louder voices than our future self.  The future selves of some clients are just too quiet to basically win the arguments and have to hope for something else.  I think it’s the case that the future selves, those cries aren’t loud enough to generate within the brain, something that would allow the activity of the reduction of consumption to take place.

 We actually know neurologically now what the different parts of the brain are that are associated with the ability to defer gratification. There are certain parts of the brain that are always involved and in some people, the part of the brain that does the mediation is sometimes very inactive.  The light bulb doesn’t come on in a way that’s really bright for those folks.  When it doesn’t come on in the way that’s really bright, then the needs of the present are especially strong.  It gives rise to behavior that from the outside, some of us would be inclined to characterize as irrational.

Douglas Goldstein:    As a financial advisor, what could I possibly do to help them to see this, to help them to make changes?

Hersh Shefrin:           If you tell them what to do, you’ll direct the cognitive part of their mind, the rational part, and that’s fine, but action only comes from generating an emotional response in them.  I think that you’re on the right track to want to induce some emotion of fear and the question is whether you can paint a picture for them of their future selves that would do the trick.  That means asking them to imagine themselves as older, to try and picture themselves as their parents, for example, in a situation where their money has run out. Ask them how they would do it, because as far as you can see that’s a situation in which they’re going to find themselves unless they behave differently.

Douglas Goldstein:    What other emotions would help to drive people other than fear?

Hersh Shefrin:           Hope. There are positive emotions and negative emotions.  Hope is the counterpart of fear and it’s the focus on opportunities as opposed to the focus on protecting your flank.  Hope is about thinking of all those things that basically stimulate the reward center in our brain.  In the situation you described, there has to be a “carrot,” something really positive that would have to be associated with spending less today in order to save for the future self.  The focus would be less on spending today and more on getting a reward, because you’re actually engaging in the activity of saving.

Douglas Goldstein:    To paint the picture of a beautiful retirement with vacations - it’s only around the corner if you could save more today.

Hersh Shefrin:           Yes, exactly, and making certain that they understand that the only way to get there is to engage in more saving today.  Cognitive dissonance is really strong, so it’s hard for us to have these two thoughts in our head that deal with a conflict, something that we want, and something that’s difficult for us to have. Some people deal with that potential conflict basically by going with what’s more comfortable even if it has long-run ramifications that aren’t so possible.

Douglas Goldstein:    For a regular investor for whom making money decisions is an incredibly stressful process, what would you recommend he should do in order to make rational decisions?

Hersh Shefrin:           True rational decisions are outside the bounds for most of us, even those academics that study behavioral commands, I’m sorry to say.  It’s just part of the human story, but I think that there’s sort of an optimal balance between reason and emotion.  We need them both.  If there’s an over focus on reason, there’s a tendency to engage in analysis paralysis.  You don’t end up actually making decisions, if emotion is too strong.  There’s a tendency to color the decision so that it is over focused, for example on the downside, by being overly fearful or not paying enough attention to the downside because we are excessively optimistic or especially hopeful about the outcomes. 

It helps to have some kind of a coach or a buddy, somebody to talk to, to help talk the emotion to the right level so that the person feels engaged enough to actually make a sensible decision and emotionally wants to do it and isn’t so overburdened by emotion that they end up doing the wrong thing.

There’s a book called Switch that was a New York Times bestseller that is excellent in terms of understanding this balance, and it typically has a three-step approach to how you deal with these kinds of issues.  One is to tell the thinking part of the brain what to do, so you direct it, and the emotional part of the brain needs to be engaged in order to actually do it, and then you need to help them move the smooth path by making this easy as possible to do what needs to be done.

Douglas Goldstein:    Could you tell people how they could keep track of your work?

Hersh Shefrin:                       I think the best thing to do is to Google me and almost the first thing that comes up would be my Santa Clara website. Just head over there and see what is new since the last time.  I try and keep that recently current.


Disclaimer: This article is for educational purposes and is not a substitute for investment advice that takes into account each individual’s special position and needs. Past performance is no guarantee of future returns.