We often speak about emotions in finance as if they are shorthand for emotional errors. We are advised to set emotions aside when making financial choices, and use reason alone.

This advice is neither feasible nor smart, for two reasons. First, people cannot set emotions aside. Second, emotional shortcuts help more than emotional errors harm. Emotional shortcuts complement reason, and the interaction between emotional shortcuts and reason is beneficial, often critically so.

Fear acts as an emotional shortcut that turns into an error when fear is absent or when it is exaggerated. Fear guides us rightly when it prompts us to retreat from a knife-wielding stranger bearing an angry face, and when it prevents us from buying houses likely to be repossessed in foreclosures. But fear guides us wrongly when it prompts us to retreat from a knife-wielding friend who chops vegetables, and when it compels us to sell all our stocks in a financial crisis.

“ Regret is painful; pride is pleasurable, and both are useful. ”

Regret and pride illustrate emotional shortcuts, errors, and their correction. Regret is unpleasant emotion we experience when we can easily imagine a different choice that would have brought a better outcome. We kick ourselves for buying a laptop computer for $1,199 when we see an ad offering it for $999 a few days later. Pride is at the opposite end of the emotional spectrum from regret. We fill with pride for buying the laptop at $1,199, before its price increases to $1,399.

Regret is painful; pride is pleasurable, and both are useful —warning us against behavior likely to inflict regret and encouraging us to toward behavior likely to generate pride. Yet regret and pride can mislead us into overlooking randomness and luck in the relation between choice and outcome.

“The cat, having sat upon a hot stove lid, will not sit upon a hot stove lid again,” said Mark Twain, “but he won’t sit upon a cold stove lid, either.” We need not kick ourselves with regret when choices that were reasonable in foresight are followed by sad outcomes, and we should not stroke ourselves with pride when choices that were unreasonable in foresight are followed by happy outcomes.

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Consider receiving a coffee mug as a gift that is yours to keep. How much would you be willing pay for such a mug if you were to buy one? And how much would you ask for the mug if you are to sell it? If you are like most people you are likely willing to pay a lower amount, say $6, for the mug if you are to buy it than the amount, say $10, you ask for the mug you own if you are to sell it. We know this tendency as the “endowment effect.” It is as if the act of being endowed with an item enhances the item’s worth in the eyes of a person who owns it. But what rationale underlies the endowment effect?

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The usual rationale offered for the effect is loss-aversion. Specifically, giving up an item we own involves a loss, a loss absent when we are considering acquiring that same item. Loss-aversion implies that we are willing give up an item we own only at a price that compensates us for the item and also for its loss. We might think of the $10 we ask for the mug as composed of $6 compensation for the mug itself and $4 as compensation for its loss.

Yet the emotional benefits of pride and especially the emotional costs of regret are likely prominent among rationales underlying the endowment effect. Think of receiving a $20 bill as a gift that is yours to keep. How many $10 bills would it take to induce you to sell your $20 bill? And how many $10 bills are you willing to pay for a $20 bill? No endowment effect is likely in this case.

Uncertainty about the market value of an item differentiates the mug case from the $20 case. So does willingness to bear the emotional cost of regret when finding, in hindsight, that you sold an item for less than its market value. You might believe that the market value of the mug is $8 but you are likely unsure about it. What if you sell the mug for $8 only to find, too late, that its market value is $10? You would suffer the emotional costs of regret. It is true that you would enjoy the emotional benefits of pride if it turns out that the market value of the mug you sold for $8 is only $6. But the emotional costs of regret are greater than the emotional benefits of pride at equal dollar amounts. A $10 price asked for a mug likely worth $8 compensates for the possible emotional costs of regret at finding, in hindsight, that the mug is worth more than $8.

“ Professional traders have learned to overcome their aversion to regret. ”

Now think of a lottery ticket you received as a gift and is yours to keep. Would you be willing to exchange it for another lottery ticket? There is no uncertainty about the odds of winning — they are the same for both tickets. But there is great uncertainty as to whether the original ticket or the exchanged one would win the lottery, and great responsibility for a decision to exchange the ticket. Imagine the emotional cost of regret if you have chosen to exchange your ticket only to find that your original ticket won the lottery. Fewer than half of people agreed to exchange a lottery ticket they received as a gift for another lottery ticket. In contrast, more than 9 in 10 agreed to exchange a pen they have received as a gift for another pen.

The endowment effect can be corrected by encouraging “thinking like a trader,” ready to bear the emotional costs of regret. Professional traders have learned to overcome their aversion to regret, and amateur traders can overcome it as well. The more general lesson is to identify your emotions — pride, regret, fear, hope, anger, sadness, happiness, and more — acknowledge your susceptibility to emotional errors, and learn correct them with reason as your guide.

Meir Statman, the Glenn Klimek Professor of Finance at Santa Clara University, is the author of “Finance for Normal People: How Investors and Markets Behave” (Oxford University Press), from which this article is adapted.

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