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Have you ever held on to a poorly performing stock because you perish the thought of selling at a loss? If so, it’s likely you’ve succumb to a form of ’emotional bias’.
In this article we’re going to touch on common emotional biases that many investors suffer from, and explain why it’s important to prevent your emotions influencing your investing decisions. Keep on reading for all the details or click on a link to head straight to a section…
While there’s a lot of good things to be said about human beings, no species is perfect. As we know, homo sapiens have a tendency to rely on emotions when making decisions.
While not necessarily a problem in our day-to-day lives, when it comes to investing, being influenced by our emotions can actually be quite harmful.
To understand why this is, it’s worth being aware of the fact that as humans, we typically suffer from two main types of biases: cognitive bias and emotional bias.
‘Cognitive bias’ refers to biases we believe to be true, even through they may not be. For example, if you buy stocks on a Tuesday because you think the stock market typically rises mid-week (even though data may suggest otherwise) then this would be an example of a cognitive bias. That’s because the decision is based on a specific belief or pattern that you perceive in the market.
‘Emotional bias’, on the other hand, refers to decisions we make based on our general feelings. For example, buying a particular stock because you’ve a ‘hunch’ it will rise in value in the coming weeks is an example of emotional bias. This is because the decision is driven by a gut feeling or intuition rather than objective analysis.
Investors typically have emotional biases deeply rooted in their psychology. This is why for many, emotional biases are often harder to overcome than cognitive biases.
There are a number of ways emotional biases can harm investors when it comes to managing their portfolios. Two of the most common include overconfidence, and the ‘loss aversion effect’.
Let’s take a look at both of these in more detail..
Overconfidence is a trait often suffered by new investors, though even vastly experienced investors can fall victim to it.
It comes in all shapes and sizes, and refers the quality of being too confident when making decisions.
When it comes to investing it’s pretty easy to see how overconfidence in ones abilities may not necessarily go hand in hand with compiling a successful portfolio.
Perhaps most obviously, an overly confident investor may lean towards riskier, short-term stocks at the expense of following a well-thought investing strategy that aligns with their investing aims, tolerance or risk.
An investor possessing an unhealthy degree of confidence is also at risk of allowing investment ‘wins’ to feed into their overconfidence, raising the likelihood of undertaking poor decisions in the future.
For example, imagine an overconfident investor believes oil industry stocks are hugely undervalued and therefore chooses to buy a handful of oil stocks. If these stocks rise in value, he/she may be tempted to believe they have a God-like ability to outperform the market. They may also start believing they’ve a knack for identifying other undervalued industries.
Of course, rational, astute investors will understand stock picking is rarely as straightforward as this. An investor suffering from a bout of overconfidence, however, is at risk of allowing their misguided self-belief to impact their investment decisions.
The ‘loss-aversion effect’ is another example of an emotional bias.
This is where an investor psychologically considers a ‘loss’ as more severe than the equivalent gain.
For example, the effect would explain why an investor might consider a £1,000 drop in their investment portfolio as far more painful than the joy they’d experience if their portfolio rose by £1,000. While there’s little that can be done about this human trait, it can become problematic if an investor uses their aversion to losses as an excuse for meddling with portfolio.
For example, say an investor puts £5,000 into a FTSE 100 tracker fund and, over the course of the year, the index rises by 2%, which is equivalent to a £100 gain. However, let’s assume that one week the FTSE 100 encounters some turmoil and by the end of the week it falls by 2%.
Under such a scenario, the recent turmoil leaves our example investor £100 down, meaning he or she is effectively back to square one.
Yet an investor suffering from the ‘loss-aversion effect’ may be tempted to feel significant sadness at this recent loss. Because of this, he/she may be inclined to sell their investments before things get worse. (Of course, just because a stock has fallen, doesn’t mean it will continue to fall – though, again, our emotional biases can cloud rational thinking.)
In this example, an investor who offloads stock following a painful loss is more likely to crystalize losses. This means they’re more likely to buy stocks at market tops and sell them at market bottoms.
If you’re a passive investor – or you allow others to manage your portfolio for you – it’s likely you’re already leaving your emotions out of your everyday investing decisions. If that’s you… congratulations!
However, if you’re an active investor, then it’s really important to understand why emotions and investing don’t mix.
For starters, as we’ve covered above, if you’re overly confident in your ability to ‘beat the market’ then it’s possible you could use this belief to ignore important variables, such as company reports or trends, when picking stocks. This is unwise, to say the least.
Also, investors who blindly follow their emotions are far more likely to meddle with their investments too often. For example, during periods of market volatility and rising interest rates – which is pretty much the situation we’re in right now – investors who allow themselves to be led by their emotions are likely to have a desire to move away from riskier equities and into other assets, irrespective of their wider investment strategy.
While moving away from equities could turn out to be wise decision in hindsight (we’ll have to wait and see), if the stock market rallies in future, then emotional-driven investors won’t enjoy these gains. This is why having a trusted investment strategy, sticking with your portfolio, and maintaining a long-term mindset is often the best course of action when it comes to investing.
If you’re not convinced that sitting tight and keeping your emotions out of your investment decisions is a wise move, then you may wish to consider some interesting research undertaken by Fidelity.
After analysing its client’s portfolios between 2003 and 2013, the investment platform discovered that its best-performing portfolios often belonged to those who hadn’t touched their investments. Of these ‘winning’ portfolios, many belonged to dead investors.
As we know, dead investors can’t be driven by their emotions, so if you want to emulate their success, it’s probably best to keep your emotions and investment portfolio at arms length.
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Disclaimer: MoneyMagpie is not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence.