Investment Psychology: Emotions Controlling Your Next Move?

Key Takeaways

• 1. Investment psychology is about understanding your behaviours and uncovering the cognitive, emotional, and social factors that influence your investment decisions.
• 2. By understanding why you act the way you do, you can avoid making irrational decisions that could impact your investment outcomes.
• 3. The best antidote for emotional investing is by developing a robust long-term investment strategy and sticking to it.

Investors may be experiencing volatility in the markets due to rapid economic and cultural changes around the world. As you continue to invest, your investment decisions and behaviour may be influenced by cognitive and social forces without you realising it.

For instance, a Schroders study revealed that while 54% of people have said they do not let politics or world events detract from their investment objectives, the evidence suggests otherwise, as respondents displayed a greater risk aversion.

Understanding how and why you invest the way you do is known as investment psychology, and gaining a deeper understanding of this helps you become a better investor. Here’s how you can use investment psychology to avoid emotional investing and achieve your desired outcomes.

What Is Investment Psychology?

Investment psychology is about understanding your behaviours and uncovering the cognitive, emotional, and social factors that influence your investment decisions. By understanding why you act the way you do, you can avoid making irrational decisions that could impact your investment outcomes.

Delving into investor’s psychology could also help explain behaviours such as overreacting or underreacting to markets, as well as being overly confident or conservative.

One way to do so is to understand the investor emotion cycle, which describes the emotions investors likely face as their investments rise and fall.

For some, they may experience reluctance and avoid entering the markets out of risk aversion, which could lead to opportunity cost. But as markets perform better, reluctance turns into optimism and they may trade more or try to time the market.

When markets start to decline, some may experience fear or denial, and an unwillingness to sell. This may then become desperation and result in panic selling as they try to cut your losses.

Understanding the investor emotion cycle, as well as your investor psychological profile, which takes into account your risk tolerance, investment plans, objectives, age and investment history among others, can help you identify potential biases and manage them to avoid emotional investing.

How Emotions Can Affect Your Investment Decisions

Emotional investing occurs when your investment decisions are based on market sentiments, or emotions, instead of analysis. It is more common than you think and often manifests when fear or greed is in the picture.

Investing works best in the long-term, but most people fall into the trap of maximising short-term gains. Being too focused on short-term performance can cause unnecessary distress and impair sound decision-making.

For example, you might be tempted to withdraw your investments or sell your shares if the market is performing poorly. But doing so would lead to more losses as compared to letting markets, and prices, recover over time.

Similarly, investors who are too optimistic may end up buying high as market sentiments inflate stock prices that are beyond their intrinsic value. Overconfident investors who try to time the market may also find themselves earning less as excessive trades chip away at their profits, as compared to someone who has a strong long-term investment strategy and keeps to it.

Ways to Manage Emotions In Investing

Avoiding emotional investing is more difficult than it seems.

According to the Schroders study, emotional investing is particularly probable among investors aged 50 and below.

Over 74% of Millennials indicated that emotion is a major influence in their financial decisions, alongside 71% of Gen X respondents and 63% of Baby Boomers who felt the same way.

However, there are steps you can take to combat emotional investing. This includes adjusting how often you check your portfolios to avoid getting swayed by market sentiments, understanding your own investor psychology and potential biases, as well as investing regularly with a long-term perspective by employing dollar-cost averaging (DCA).

The best antidote for emotional investing is by developing a robust long term investment strategy, and sticking to it.

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