‘Keep calm and carry on’ is the mantra investors need when it comes to implementing their investment strategy, especially when market volatility starts to raise anxiety levels.
Many investors have made decisions or locked in losses by making emotional decisions and reacting to every market movement due to feelings of fear, panic or greed.
When it comes to managing our money and making sound decisions, these emotions are often powerful motivators that seldom lead to rational thinking. Rather, a disciplined approach to investing creates long-term wealth.
Insights from behavioural economics
Due to the influence of emotions on investing, numerous studies have looked to better understand investor behaviour and explain the remorse or overreaction that investors often experience when it comes to losing money or missing opportunities.
Behavioural economics, which combines the psychology of financial and economic incentives and human behaviour, offers important insights into the decisions we make when it comes to money and investments.
This fascinating area of study shows us that investors aren’t always the rational, profit-maximising beings that traditional economic models assume they are.
Instead, their decisions are often influenced by various psychological factors, leading to predictable biases and errors, like buying at market highs and selling at market bottoms.
For instance, investors tend to seek out information that confirms their existing beliefs and ignore contradictory evidence.
We also know that many investors overestimate their abilities and knowledge, which can cause them to take on excessive risk.
In addition, people often fall into the herd mentality of following the crowd, even if it means making irrational decisions. This can contribute to market bubbles and crashes.
When it comes to cutting our losses, people typically feel the pain of a loss more strongly than the pleasure of an equivalent gain, which is why we try to avoid it. This ‘loss aversion’ can cause investors to hold onto losing investments for too long, or average down by adding to a losing position, hoping the price will eventually rebound.
Recognise the power of emotions on investing
Understanding these common traits can help investors identify and avoid unconscious behaviours that may lead to poor investment decisions and outcomes.
It is important to acknowledge that emotions can overpower rational thinking in response to market fluctuations, whether that stress is a result of euphoria or panic.
An inability to control emotions can make it difficult for investors to stay focused on their long-term strategy, which can impact returns.
How to keep your emotions in check
Learning how to control emotions in investing will help you take a rational and realistic approach to investing.
- Plan the trade, trade the plan: A critical success factor in any risk mitigation strategy is meticulously planning every trade and then trading the plan. Having an investment plan and sticking to it is the best way to avoid the sway of emotion in trading. Traders who adhere to the strategy and stick to their defined entry and exit points by keeping their emotions out of the decision-making process are more likely to avoid mistakes.
- Plan for the worst, hope for the best: Plummeting markets trigger panic selling as investments only see the short-term loss to their portfolios. Try to see the bigger picture and remain focused on the long-term plan. Making emotional, impulsive decisions can hinder the success of your portfolio.
- Engage your rational mind: When you start feeling anxious about market movements or overly excited about a potential trade, try to base your investment decisions on objective analysis rather than emotions. Interrogate your views and examine your motives for making any change to your plan.
- Diversify your portfolio: Diversification can help reduce the emotional response to market volatility as all markets and asset classes seldom move in unison. In normal market cycles, diversification provides an element of protection because losses in some investments are offset by gains in others, which can make it easier to take losses in your stride.
- Create rules: Create a rules-based approach to investing by setting rules and sticking to them to eliminate emotion from the equation when making decisions.
- Avoid the daily news cycle: The amount of financial market news and the tendency to focus on bad news over positive factors can trigger emotions around your investments. Try to limit your exposure to market news and focus on trusted sources of investing advice instead.
- Ask for help: During stressful periods, guidance from a financial professional can help you stay on track and avoid short-sighted decisions that have a long-term impact on your returns.
Keep your emotions in check
Taking the emotion out of investing and making rational, informed decisions based on your plan, not your gut feeling is crucial for long-term success.
By developing a solid plan, diversifying your portfolio, focusing on the long term, and managing your emotions, you can increase your chances of achieving your investment goals.
