Did you know the biggest threat to your investments is you?
Emotional investing is when you let your feelings get in the way of your decision making processes. You may believe you are making a rational well thought out decision but unconscious influences such as cognitive biases may be working against you.
Benjamin Graham famously said, "Individuals who cannot master their emotions are ill-suited to profit from the investment process." If this is the case then all smart investors should learn to master their emotions but before they can do this it helps to know what to look out for.
There are certain patterns of behaviour that are common to many of us, whether we are aware of them or not. So in this blog, I will look at some of the most common emotional pitfalls investors can fall into and then give you my top rational investment strategies to help you avoid making them yourself.
What Causes Emotional Investing
There is a premise on Wall Street that “financial markets are driven by two powerful emotions – greed and fear.”
Greed and fear may be what motivates us when it comes to investing, but emotional investing goes deeper than this. Your mind creates rational explanations for its emotional decisions and below I look at some of the most common causes of investing irrationally
Confirmation Bias
People have a tendency to seek out, interpret and recall information that will support their beliefs and conversely they are more likely to give less weight to information that challenges them.
For example in investing if you want to believe active management wins over just passively tracking an index you will focus on the individual success stories of active managers rather than looking at the overall comparison figures for passive versus active management.
Availability Bias
Availability bias means thinking that just because you can easily recall something then it must be important. The truth about memory is that we tend to remember the things that have made an impact on us or that have happened most recently.
Events that are out of the ordinary tend to make a bigger impact on us than everyday boring occurrences. Coupled with this, these out of the ordinary events get far more press coverage and are more likely to be the subject of prolonged discussion.
As a result of easily remembering these out of the ordinary events, we then tend to register them as having a far higher probability than they actually do.
We also tend to recall the recent past more easily than events that happened further back in the time and this is called recency bias. Recency bias can cause us to normalise something like current market conditions and forget that 10 years previously things were totally different.
Gratification Bias
There is a tendency for people to be more positive about gains that can be realised quickly than even greater gains that are only realised after a longer period of time. Gratification bias can cause a number of issues for investors including making short term high-risk investments rather than developing a long term investment plan that will only deliver its benefits in the future.
Loss Aversion Bias
Loss aversion is the established tendency for people to dislike losing something more than they like gaining it. It does seem counterintuitive that people prefer not to lose more than they do to win but in research, by Kahneman & Tversky in 1992, they found that those losses were actually twice as powerful, psychologically, as gains.
Loss aversion can cause investors to make bad decisions as it can influence them to sell too quickly or hold on too long before selling.
Bandwagon Effect
Wanting to follow the crowd is a natural human instinct as It can make us feel comfortable that we are not alone in our thinking. However, following the crowd may not always be the best course of action for investment decisions.
Warren Buffett’s advice to be “greedy when others are fearful and fearful when others are greedy” advocates against following herd behaviour. Put simply he is saying buy stocks when prices are cheap and everyone else is selling and sell when prices are high and others are buying.
Status Quo Bias
For a lot of people change is difficult. It can feel safer to stay doing what you have always done rather than face the fear of change. Because of this, some investors may stick with the same investments or strategies for longer than they should, despite it being obvious logically that they are well overdue a change.
Optimism Bias
People often have a tendency to overestimate the probability of positive outcomes and underestimate the potential for a negative one. This common human trait probably accounts in part for why countless numbers of people buy EuroMillions lottery tickets each week even though there is only 1:140 million chance of winning the jackpot.
5 Ways To Prevent Emotional Investing
Make Sure You Have an Investment Plan and Stick to It
If you have taken the time to write down an investment plan then you are far more likely to stick to it than if you just have some vague ideas stored in your mind.
The very act of creating an investment plan can not only help you understand what you want to achieve and how you intend to get it but it can also help you contingency plan for “what if..” scenarios.
The process should also help you understand things like your risk tolerance level to make sure you are not tempted to hold more risk than you're comfortable with. This in turn should make you less likely to panic and sell at exactly the wrong time.
Diversify Your Investments
By having a mix of different types of assets you can balance your portfolio to your specific risk appetite. For example, choosing some less risky assets such as developed market government bonds along with your equity may make you less likely to panic if you see the price of stocks going down.
Additionally, you should look at other factors and not just the asset class to make sure your investments are not too concentrated. Examples of this are investments that relate to just one industry sector or just one country.
Keep It Simple
If you are continually having to re-evaluate how you are investing then there is more scope for emotional investing mistakes to creep in. You could make investing as easy as possible through something like dollar-cost averaging or consider using multi-asset or robo funds that will rebalance automatically and keep you to your target asset allocation.
Multi-Asset Funds offer a one-fund solution to investing because they are diversified across asset types and regions. If you would like to find out more about multi-asset funds or dollar-cost averaging you can view my videos by clicking on the links below.
Understand Market Data
The stock market may not be rational on a daily basis but certain trends do tend to prevail historically over the longer term.
If you understand how the market and the economy have worked in the past then you are less likely to be swayed by a sensationalised stock market news story or by a friend’s grand claims of being able to make millions by investing in an unheard of company.
Also when making investment decisions remember to actively seek out information and data that challenge your views, not just support them. This will help you to avoid any confirmation bias tendencies you may have.
Sense Check Your Decisions Before Acting on Them
It helps to be able to talk things through before you make any rash decisions, but financial advice can be expensive. We have a blog all about this and you can read this by clicking on the link How Much Does Financial Advice Cost?
Alternatively, you could book a Power Hour With Ramin and use it to talk through your decision-making processes.
Unlike financial advisors, PensionCraft won’t financially benefit from any of the investing decisions you make. We just offer unbiased investment coaching and education to help you to become a better investor so that you can be prepared and informed when it comes to making your own investment decisions. You can click on the link to find out more about booking a Power Hour With Ramin
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