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How to break the cycle of emotional investing today – and become the best investor you can possibly be!
There’s no escaping it, humans are emotional creatures. And in the field of investing, which is predicated on making rational and logical decisions, there is no room for emotional decision making.
In fact, one of the biggest skills you will have to master as an investor is that of controlling your own emotions. In the words of Warren Buffet’s very own mentor, the great investor Benjamin Graham:
“The investor’s chief problem—and even his worst enemy—is likely to be himself.”
To see this in action you need to look no further than the ‘Cycle of Investor Emotions’. This is a representation of the varying emotional states that accompany a typical market cycle, with the line representing asset prices through a rising market, and then an ensuing recession:
But why? What is it about us humans that makes us such irrational creatures? The answer is ‘biases’, which could otherwise be defined as ‘behavioural mistakes’. The field of Behavioural Economics identifies a long list of biases that, due to human nature, may hinder or impede our decision-making ability. This is especially apparent when we have to make a large number of decisions – as is exactly the case when investing.
In order to understand how some of these behavioural biases may be present for you, we have applied some of the more common ones to the context of investing. Be honest, do any of these sound familiar?
This essentially means assigning different pots of money different meanings according to where the funds came from. For example, if you earned £100,000 throughout a year-long slog in an especially challenging corporate gig then you may assign that a higher value in your mind than if you were to be gifted £100,000 – or vice versa. It is all dependent on your personal circumstances. This can have a massive impact on how you treat that cash when investing. Investopedia has a fantastic article on the intricacies of mental accounting here:
Our brains are inherently lazy and will take a myriad of ‘shortcuts’ to consume less energy. Heuristics are a specific type of mental shortcut, which we use to simplify decision making. There would be nothing wrong with using heuristics – if they were always accurate! However, in reality, heuristics are only sometimes useful, and frequently lead to bad decisions. An example of this in the context of investing would be the “rule” to keep 100 minus your age as a stock allocation – overly simplistic and rarely accurate when taking all other personal aspects into account.
Risk and Loss Aversion
This is a big one in the world of investing – and business! In fact, in any arena where there is money to be made and/or lost. Risk and loss aversion concerns our tendency to associate greater pain with making a loss than pleasure with making a gain. In fact, investors are likely to feel the pain of a loss more than twice as strongly as they feel the enjoyment of making a profit. Unfortunately, what this means more often than not is that the investor will hang on to their losers, and sell their winners.
The Sunk Cost Fallacy
This bias is very similar to loss aversion. In this instance we evaluate the future prospects of an opportunity depending on how much time, effort or resource we have already invested in it. In the same way that you would sit through bad film in the cinema just because you have already paid for the ticket and don’t want to ‘waste’ it, you may be tempted to cling onto bad investments, “throwing good money after bad.”
What’s the solution?
So, with all of that being said, are we doomed to be slaves to our emotions, and to never truly conquer the game that is investing?
Actually, those who removed emotions from their investing and adopted a behaviour modified approach saw returns up to 23% higher over 10 years, according to a 2018 study published in the Journal of Financial Planning.
So while it may be impossible to completely override our human predispositions, you can certainly ‘train your brain’ to recognise when you’re making those emotionally-driven decisions. By adopting the 5 simple principles below, you can begin your journey to becoming a better investor, thus minimising the likelihood of losing money – and maximising your returns!
1. Take a long term view
Realise that markets are cyclical and that, if you’re in it for the long run (as you should be), then you will experience your fair share of recessions and market crashes. What differentiates a successful investor from the herd is his or her ability to weather these storms without panicking – and to resist succumbing to the herd mentality. Stick to the age old adage: “Be greedy when others are fearful and fearful when others are greedy”. Thanks again, Mr Buffett!
2. Don’t try and time the market
Drawing on from the previous point: do not try to time the market. Many professional, seasoned investors who spend their lives studying the market have failed to do so, so what’s the likelihood that you’ll be able to successfully? Plus, fluctuating values account for only a portion of your potential returns. With property or dividend-paying stocks, for example, you would be missing out on rental yields during the time that you’re dithering. Sit out the market, and you miss out on the income produced by investments.
3. Diversify your portfolio
Spread your money across different asset classes. And within that each asset class, different asset types. The percentage of your pot that you invest into each is called your asset allocation, and this varies according to your age, goals, and other lifestyle factors. A simple concept, yet one that investors seem to conveniently ignore! The best way to stress this point is to imagine if you had invested 100% of your wealth into Enron in the early 2000s. Where would you be now?
4. Research high-risk investments
Back to the wise words of Mr. Warren Buffett here: “Never invest in a business you cannot understand.” And if that investment is offering you a high return, then it is more than likely to also be high risk. What this means is that you must do your research. Investing is a life-long endeavor, and you can never stop learning. Make it your priority to understand the fundamentals of the companies or products you’re investing in, and this should minimise the risk of you making major mistakes – although as we all know, this isn’t foolproof.
5. Automate your investments
Take the human aspect out of investing, and you also remove the risk of emotions. Seems straightforward, right? There are both advantages and disadvantages to “robo-advisors”, but one thing they do well is propose investments and then automate them for you. What this does is reduce the temptation for you to go and sell when the market is crashing, and buy just because it’s rising. When everything is on autopilot, you can keep your head down and focused on the long term – as any good investor would be doing.
These are just some of the steps you can take on your path to becoming a better investor. If you would like some further insight into how to avoid emotional investing, then Investopedia has another great article on it here.
Otherwise, feel free to reach out to our team with any questions! And start your investment journey today.