The trap of emotion in investing

PUBLISHED: Wed, 24 Mar 2021 09:24:46 GMT
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This article is part of an ongoing series of basic financial education brought to you by financial industry professionals curated by PocketFin – The Financial School of Real LifeCNBC Africa provides content from PocketFin as a service to its readers but does not edit the articles it publishes. CNBC Africa is not responsible for the content provided by PocketFin.

The emotional investor

Investing in any aggressive market such as the stock market is often influenced by your personal emotions and short-term market movements. The concept of the “emotional investor” can affect all of us and can be deadly to our investment strategy.

Photo by Justin Snyder Photo on Unsplash

If you are caught in a dilemma whether to further invest in a deteriorating stock in which you have lost, say, 40% over the short to medium term, so that you can average out your investments or put your money in a promising company that could reap you rich dividends or dramatic capital gain, which would you choose? This event affects most of us and often blocks us from making rational investment decisions. Often, investors choose the former to cover up losses in their portfolio or just hold on to the investment in the hope that it will bounce back at some point. Investors tend to behave in this way because the pain of loss far exceeds the pleasure from gains. It’s this emotion of “loss aversion” that many investors succumb to when making investment decisions. Often, not understanding one’s emotions when investing in any volatile market leads to big financial losses for investors.

There has been a lot of research that has gone into how emotions affect investment decisions of individuals. Emotions are shaped by many influences in our lives and our upbringing, including basic things like how we react to money or how our parents reacted to money, these habits were ingrained in us from a young age.
Emotions also determine how we react to different situations. Especially in a time of exorbitant returns through the likes of the tech stocks rally in 2020, or the explosion of the crypto currency market, we have become used to experiencing or at least hearing about dramatic returns in a very short space of time.

Think prudently about your emotions

If you had done very well on a particular stock or investment before, it does not mean that you will automatically do well on it again. Each investment calls for fresh understanding of the investment type,market conditions and the circumstances that will allow you to do well.

The most lethal and common trap investors can fall into when they are driven by emotions is when they try to recover a loss that has occured. At such times, it is popular for some investors to commit a larger sum of money to recover his or her loss in the investment. In doing so, they fail to recognise that their risk capital and exposure to the market has increased. Instead of taking this approach, think carefully about what the potential of this investment could be far down the line, if it is still a worthwhile investment rather consider doing a monthly contribution to bring down your average purchasing price (this is known as cost-average investing)

Understand investments today are not as easy as it was in the past

Recently, people find it difficult to understand markets, if we look at the current state of the global stock exchanges whereby most have hit an all time high, it does not correlate to the state of both micro or macro economics globally due to the Covid-19 pandemic.

It’s said that markets are efficient. But behavioural economists believe that markets are not efficient in the short run. It’s exactly in these times that people don’t make rational decisions. When these days a liquidator is selling stocks at any price, can you imagine the potential you have when you invest today? Right now, everyone wants to avoid a loss while it may be the time to buy, this has become the norm.

Having your emotions telling you to sell at a loss

If I sell an investment after the market falls, I make a loss, a real monetary loss. So, my actions have produced a loss for me. But other shareholders, by merely holding the same shares, too, see their values plummet. It’s when you don’t do anything and yet there’s a reaction, then you get confused. This is when greed and fear overcome us. Right now, everyone wants to avoid a loss, which is known as “loss aversion” in behavioural finance. This is the time to buy. The famous Warren Buffet said “be fearful when others are greedy and be greedy when others are fearful” , and this is an incredible philosophy which has made Mr Buffet one of the wealthiest people in the world.

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Think carefully

Instead of pulling the trigger on any investment that comes across the news or is the talk of the town due to its massive return, first take a step back and do your research, determine if the willingness to buy this particular investment is an emotionally based decision, or a carefully thought out decision.The key to wealth building is to balance your investment decisions with your objectives and the circumstances of the market. Remember that the ultimate advice for a successful financial plan is diversification, therefore even if you had made an emotional investment and it failed, there are other investments to help balance your wealth and your investment portfolio returns.