Placing too much emotion in your investing decisions can cost you. Here’s how to adopt a calmer, more rational approach.
A closer look at financial markets shows that investors are quickly changing from the simple adage of buying low and selling high. Instead, the players actively monitor their portfolios to manage the notorious market swings in real-time.
However, active monitoring tends to trigger investor emotions occasioned by the high volatility. Today, emotional investing is a concern for investors.
This article dives deeper into emotional investing, why it happens, and ways to avoid it.
What is emotional investing?
It’s the nature of humans for their decisions and behaviour to be influenced by combinations of psychological factors. For example, one critical aspect in financial decisions is the stock market emotion, which considerably drives investors’ decisions in stocks. But for one to be a successful investor, it’s always good to keep one’s emotions in check.
Yet, that is easier said than done. Expert investors bag on deep technical analysis in search of the best market trend predictors. However, they are never completely off the emotional investing hook. Most of them focus on the maximum returns opportunities, making them vulnerable to exhibiting impulsive investment behaviour.
That said, we can sum up emotional investing as investment decisions based on the investor’s behavioural impulses as influenced by the market trends rather than fundamentals like technical analysis.
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Reasons for emotional investing
Emotional investing is more of a cycle than a spontaneous occurrence in financial markets like stocks. It is so because market trends involve up and down movements, and investors react to these swings. Typically, four different stages trigger emotional investment decisions.
Stage one: optimism stage
A bullish trend usually characterises the optimism phase. The market values rise relentlessly, and investors feel enthusiastic and highly excited as their balances grow. As a result, many investors oblivious of the market trends feel tempted to join, completely disregarding their risk tolerance levels.
The exuberance keeps building up if the market rally continues for prolonged periods. As a result, even seasoned investors may feel they can tolerate higher risk levels.
Stage two: anxiety stage
The anxiety phase is quite difficult to pinpoint. Investors become filled with mixed feelings of fear, despair, and denial. In most cases, only expert investors or those who understand emotional investment psychology pull through this phase.
The market gets the closest to the peak and surpasses the point, leaving investors in utter confusion, wondering, “Is the market peaking? Is this the start of a bear market? Or is it time to get out?”
The sudden turn of the trend triggers different decisions among investors. Some are confident it’s a temporary downtrend, while others simply follow the crowd.
Stage three: panic stage
The downturn continues, and investors begin to panic. Now, most of them, including those who were earlier confident the downtrend is temporary, want to divest. The realities of a bearish trend are now apparent, and investors are now desperate and in capitulation, having already lost some figures. They want to pull out and prevent any further loss, and even those who maintain their investments are not confident of a recovery.
Stage four: dismay and hope
It is the last stage of the emotional investment cycle and is almost similar to the first stage. Here, the market begins a bull market after an extreme low. Investors who pulled out are in dismay, while those who retained their investments start to feel relief and hope the upward trend continues.
Potential investors are unsure whether the trend will continue, and those who pulled out may be reluctant to reinvest. However, as the prices rise, the hope builds up, and more people are willing to join in the bull run.
How to avoid emotional investing
The first step to avoiding emotional investing is acknowledging and understanding emotional investment psychology. Appreciate that you are subject to extreme emotional impulses based on the financial markets movements, and that the emotions often push you against sound investing decisions.
While investors can keep emotions in check, it’s not an easy feat, especially if you actively monitor the movements. The emotional impulses may be overwhelming at some point, forcing you to make a seemingly right decision.
Here are some of the strategies you can use and stay away from emotional investing entirely.
Financial markets provide a wide range of investment tools like stocks and bonds. Therefore, investors can diversify their portfolios by having several instruments rather than just a few. In addition, it is rare for different investment tools to follow the same trend simultaneously, so diversifying investments will provide some protection.
Besides, the financial market is broad, so one can even invest in different industries to spread the risks. Losses from one sector are offset by other industries' gains and help avoid potential emotional responses.
Dollar-cost averaging (DCA)
Dollar-cost averaging is one of the most effective strategies to help investors avoid market emotions. Here, investors are passively involved as the buying process is automated.
Instead of investing a specific dollar amount simultaneously, the total amount gets divided in equal amounts, invested at predetermined intervals. Investments will happen automatically regardless of the market condition. The shares purchased at the different times, bullish and bearish markets help mitigate the overall impacts of volatility.
The strategy systematically distributes investments and ensures the investor avoids the possible mistake of making a lump sum buy-in at the wrong time. In addition, it is an excellent technique for investors with a paycheck as employers only effect instructions to deduct a fixed amount from each paycheck for investment.
Summing it up
Although it can be a difficult principle to effect, emotions have no place in your investment decisions. They will always fight you tooth and nail and can be pretty detrimental to your investment returns.
A study published in the Journal of Financial Planning revealed that investors who adopt a behaviour-modified strategy to investing independent of emotions recorded 23% higher returns over 10 years. That means investors can get through the complex emotional investing cycle by focusing on the long-term investment plans instead of the behavioural impulse to leverage their money more effectively.
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