Whilst we all like to think we are rational, logical beings who use considered judgements when making important decisions, the truth is that most of the decisions we make are based on emotion. Decisions on investing money are no different to many other important decisions in our lives.
There is a cycle of investor emotion as depicted in the graph below. This graph shows a typical cycle over time of emotions ranging from optimism to euphoria then fear leading to desperation before returning to optimism again when the whole cycle repeats itself. These are all emotions you might experience when you invest.
John D. Rockefeller once said: “The way to make money is to buy when blood is running in the streets.”
Warren Buffett echoed this statement when he said:” Be fearful when others are greedy, and be greedy when others are fearful.”
What’s interesting about these two statements is that they address the emotional, rather than financial, element of investing.
The challenge is in deciding when we are at the desperation stage when “blood is running in the streets.” That’s because it requires you to time the market but market timing is virtually impossible to get right.
Getting sentimental over investments, fear of missing out (FOMO) on gains or losing all your money can lead to making wrong decisions. A prudent way to deal with emotions and biases is to have your money managed by a wealth manager to ensure better outcomes over a period of time and to prevent you from making poor investment decisions based on emotions.
Investors make decisions based on psychological factors, including emotions, and may place undue weight on specific information at the expense of other relevant data. Different emotional states can have unpredictable effects on decision-making at different times.
Emotional attachment to certain shares can affect investors’ behaviour too. You may have inherited some shares from parents or grandparents, you may have been given free or low-cost shares through an employer or you may have benefited from receiving shares from privatisations when building societies demutualised or public sector industries were privatised. Whichever way you acquired the shares you could become emotionally attached to them. The problem is it rarely benefits you to invest in shares this way because it blinds you to the company’s weaknesses. It often means you have a disproportionate amount of your wealth invested in a poor-quality company too.
Why do the supporters of behavioral finance suggest that emotions lead to inferior investment decisions? … Emotions lead to inferior investment decisions, as people are motivated to buy and sell based on their emotional reactions. For example, an investor may be motivated by greed when buying and by fear when selling.
Most bad investment scenarios can be avoided by following seven simple rules.
- Avoid investments with early surrender penalties.
- Be cautious of illiquid investments.
- Avoid investments that have high upfront charges.
- Avoid confusing investments.
- Don’t put all your money in the same type of investment.
- Ensure your investments have adequate FSCS investor protection
- Make sure your investments are registered with a custodian.
Above all else, appoint a reputable financial planner or wealth manager to manage your investments. Avoid checking your valuations daily. You should only need to check valuations once a quarter at most and ideally once a year only. It’s your adviser’s responsibility to monitor your investments daily. Let your adviser take the strain. * You know it makes sense.
**The contents of this blog are for information purposes only and do not constitute individual advice. The blog is based on my own opinion. You should always seek professional advice from a specialist. All information is based on our current understanding of taxation, legislation and regulations in the current tax year. Any levels and bases of and relief from taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future.