- July 16, 2014
- Posted by: Stream Financial
- Category: News
There is more to investing than finding the ‘right’ strategy, making an investment and following a plan. Being aware of how you think, why you react in certain ways and what biases or beliefs you might have will increase your skills as investor. Not controlling the emotions you might experience such as fear, greed, pride, ego or denial, may impact on the way you invest and, more importantly, on the decisions you make concerning your investments.
Conventional theory tells us we collect the necessary information and make rational investment decisions. It does not consider all situations that happen in the real world. If it was true, investors would not continuously fall prey to emotional investment behaviour.
The study of this ‘emotional’ behaviour is called behavioural finance or behavioural economics. It combines the disciplines of psychology and economics to explain why and how people make seemingly irrational or illogical decisions when they spend, invest, save, and borrow money.
5 common ‘Emotional’ mistakes investors fall prey to:
- Being emotionally attached to investments
Becoming emotionally attached to investments can cloud your judgement. You may ignore your money management rules or ignore negative information that the markets are telling you. This can lead to disaster. Instead, become attached to the effectiveness of your investment plan which lets you enter and exit an investment with a calm, focused and disciplined approach.
- Not having an exit strategy
It is important to accept that not all investments turn out successfully and that it is normal and acceptable to take a loss. Studies show that people suffer almost twice as much pain losing $1 as they feel pleasure in gaining $1 (Kahneman and Tversky, 1991). This is what motivates investors to hold onto investments making losses rather than selling to preserve their capital so that they can invest another day. Their rationale is that until the investment is actually sold, they have not made a loss. This is not logical. Before commencing an investment, decide on what the maximum loss is you are prepared to accept. Understand should you reach that point, you will exit the investment. You need to manage your risk, take losses when your investment plan says and not let small losses turn into big ones. Accept losses as part of investing and focus on preserving your capital so that you can continue to invest.
- Searching for a ‘Get Rich Quick Scheme’ or a Guru
Often investor’s will read a book and apply the strategies. If there are wins in the beginning, they begin to feel confident. Once loses are incurred, strategies are abandoned as not working. The investor then moves onto the next book or guru’s ideas. To become a successful investor it is crucial that you can recognise this behaviour and stop it. It is important to accept that an investment strategy may not always produce a winner. Understand how managing the losses and wins is a more effective way to achieve success.
- Following the herd
Investors tend to follow each other for no other reason than avoiding feeling left out or assuming the herd cannot be wrong. Herding is most prominent when markets start to go down or up. Investors get scared and follow each other by exiting the market. Not returning until things look positive again. Much wealth has been lost to such behaviour. Frequently buying and selling investments incurs substantial transaction costs, which can eat away at profits. The achievement of real wealth is not determined by investment performance but by investor behaviour. Investors need to avoid the urge to join the herd and instead review their investment plans and strategies to determine if any changes are necessary.
- Market timing
It has been proved that you cannot time the market and consistently make a profit. There are too many factors involved. Bad timing has caused many investors to incur losses as they bought high and sold low. Instead of waiting for the ‘magic’ cue of when to enter or exit the market, simply just get started. Spend time determining how much you want to invest, what you want to achieve from your investments, your investment timeframe and exit strategy. Using this approach will set you on your path to building wealth in a more controlled and effective way.
By spending the time to gain a better understanding of how you think, becoming aware of your flaws and developing a discipline to combat negative emotional effects, you should become a more effective and successful investor. Putting processes and techniques in place to avoid and reduce the impact of your emotional behaviour, should be an essential part of your disciplined approach to investing.