How Emotions Keep You from Taking Smart Investment Decisions
Being an investor in a financial market, a person must be able to control his or her emotions, because buying low and selling high may not be possible if emotions get in the way and adversely affect the investment decision. Most people tend to underrate the effects of emotions, whereas, market downturn is one of the factors that increase hospitalization rates when emotions run high.
Getting emotional in a financial world distorts even the best planned strategies. This is the reason why investors are advised to use reason and not emotions when making a financial decision. According to 2013 Dalbar Quantitative Analysis of Investor Behavior, emotions and the behaviors triggered by those emotions were partly the cause why investors underperformed the S&P 500 by almost 4 points over the last 20 years. This was because the element of desire to grab a hot investment and to sell losers for the avoidance of further losses tends to create a pattern of buying high and selling low.
Investors are most vulnerable when there is high volatility in the markets. That’s where emotions trigger panic, depression, capitulation and fear. However, by taking control, investors can prevent their emotions from affecting their decisions.
- How many times you regretted the investment decision that you made? If you come to think of it, there would probably be quite a few that come to mind.
- What caused it?
- Was it lack of knowledge about the market, bad timings, or did your emotions play the part?
Following are some of the behavioral finance concepts that reflect how emotions can have a real impact on an investor’s ability to a sound financial decision:
Having a Short-term Thinking Process
People tend to disregard and ignore future benefits as compared to the more immediate ones. So, oftentimes, it becomes harder to make long term financial plans a priority in everyday life decisions. For example, everyone understands the value of saving for retirement or college education of a child, yet, find it difficult not to spend lavishly on buying a new car or a vacation.
Fearing Losses more than Valuing Rewards
Considering the aspect of behavioral finance, i.e., fearing losses more than valuing rewards, which is mainly triggered by short term thinking, it can become very problematic for an investor to take the right decision. This phenomenon is normally called loss aversion, as it leads to a risk averse behavior that eventually exposes the investment to a greater risk. For example, although, investors rationally understand that the markets will bounce back from a downturn, yet, the emotions instigate them to overreact.
As the behavioral economist, Richard Thaler, said, “We think we will be smart enough to take the long view, but when markets actually drop we lose our courage and sell at the bottom.”
Studies have shown that a large majority of investors consider themselves above average despite the fact that not everyone can be above average. According to the findings of a study conducted by Glaser and Weber (2007), investors overestimated their investment performance by 11.5 percent per year. Thaler said that people think they are better than everyone else, regardless of the evidence that most people fail to beat the market.
For example, in a rising market, investors might believe that it is their own performance that is causing them to succeed, which might cause them to ignore warning signals or the need to caution, eventually leading to unavoidable losses.
There are so many other emotional factors that can jeopardize the investing behavior and a well devised long-term financial plan of an investor, and these are as follows:
If an investor gets overwhelmed by a heavy stream of real-time information, he or she would start reacting to every twist and turn in the market, which might expose them to risky situations.
In any market, the greed to make more may tempt an investor to seek more growth in the value of his investment, but what they do not realize is that higher returns also mean higher risk.
The enchantment to see the stock going up day by day makes an investor falls into a trap of believing that success is self-perpetuating. He can easily get caught up in a bubble mentality.
So, even if we think we are being rational and analytical while making a move, deep down under the surface, emotions are always working in ways we cannot escape and may never entirely understand, which can keep us from taking smart investment decisions.