How understanding your emotions can make you a better investor
Investing can be an emotional process, and even the most level-headed investor can find themselves being swept up by the fluctuations of investment markets.
When it comes to growing your wealth over the long term, one of the best ways to make better decisions is to understand the psychology behind investing.
Our brains are still adapted to the threats that we faced hundreds of thousands of years ago. But we now live in a different era, in which they can sometimes lead us to make poor decisions.
The most common investment mistakes (biases) can be grouped into four categories:
Ego
Emotion
Attention
Conservatism.
1. Ego (Over-confidence)
In investing, overconfidence often leads to people overestimating their understanding of the market or specific investments. This often results in ill-advised attempts to time the market or build concentrations in risky investments.
Professional investment managers have one significant advantage – they are trained to understand the impact of biases and can attempt to mitigate the risks. That’s why it’s generally better to spread your portfolio across a range of expertly managed investments.
2. Emotion (Letting feelings cloud your judgement)
Our feelings can colour our judgments of risk and reward, and to influence our decision-making process.
The mood you’re in influences the way that you see the world. Someone in a great mood would perceive risk differently to the same person in a bad mood. People become more optimistic and self-confident when investment values rise, only to descend into fear when they fall.
Avoiding over-reacting is key to long-term investment success. The best thing an investor can do is to know themselves and be ready to manage their emotions when markets rise and fall.
If you’re feeling at an emotional extreme, whether it be greed or fear, it’s probably a good idea to avoid acting on those feelings. Taking personal financial planning advice can help you to contextualise what you’re going through.
Meanwhile, automating a regular monthly payment into a plan can also help to remove emotion from the investing process, and average out the ups and the downs.
3. Attention (Reacting to short-term noise)
As investors, it can be all too tempting to try to react to events as they happen. That’s because our brains are hard-wired to confuse how striking an event is with how likely it is to happen.
For example, animal attacks capture the public imagination and yet they’re extremely uncommon. More real risks, like heart disease or diabetes, are harder to imagine – and so we under-weight them.
As investors, the answer is to try and avoid reacting to short-term events.
The best investors do not seek to time the market by forecasting (or reacting to) short-term events. Rather, they know that uncertainty is what they are being rewarded for, and so they adopt principles for the long term.
Such an approach may lack the excitement of responding to every news headline and market turn, but it will enable you to keep your eyes focused on the horizon.
Regularly meeting with a financial planner can help you stick to those goals.
4. Conservatism (Playing it too safe)
We are all hard-wired for safety. It enabled our ancestors to survive times when resources were scarce. Today, this conservatism could lead you to avoid less familiar investments and taking less investment risk than you should. Over a lifetime, this could cost you thousands of pounds.
‘Conservatism’ describes our asymmetrical fear of loss, versus our happiness about reward.
People are two-and-a-half times more upset by a loss than they are happy about a comparably-sized gain. So, winning P1,000 is no big deal. But if you lose P1,000, you’re upset. We see this in investment markets too.
However, holding on to an investment irrespective of how it performs can end up doing damage too. Periodic portfolio reviews, ensure you are holding investment for good reasons.
If you’d like to know more about how to make better investment decisions, then speaking to an SCI financial planner is a good place to start.
They will help ensure that you make the right decisions to ensure your long-term financial wellbeing.