Avoiding Emotion Driven Investments Decisions
If asked, most investors would say that they make well-considered decisions when it comes to their portfolio. Most believe that they adhere to a thoughtful, disciplined approach that includes a thorough analysis of options and consideration of principal risk vs. potential return.
The reality is that investment decisions are often driven by emotions. Research in neuroeconomics, a multi-disciplined field which works to understand why investors make decisions, suggests that we are still influenced by ancient instincts when making financial decisions.
Primitive Instincts Cloud Decisions
Before civilization, human being’s survival depended on instincts. One was the ability to quickly analyze a situation based on limited information. Another was the ability to detect and interpret patterns. Blue berries are good to eat, orange berries make you sick. These and other instincts helped our ancestors survive, but they are often an impediment when it comes to making investment decisions.
So, how can we mitigate the impact these primitive emotional reactions have? First and foremost, it’s important to recognize that everyone is subject to irrational fears and unrealistic expectations. Even Harry M. Markowitz, the renowned economist who won a Nobel prize for modern portfolio diversification theory, can fall victim to emotion-based investing. The story goes that Mr. Markowitz was figuring out how to allocate his retirement account. He knew that he should utilize his own portfolio diversification model, but was unable to divorce himself from the fear of losing out on stock market gains and simply split his holdings 50/50 between stocks and bonds.
Understanding Emotional Triggers
Our ancient brains are trained to be risk adverse and react swiftly to bad news by quickly extricating ourselves from “danger.” Therefore, we tend to over react to bad news. We only focus on the immediate, allowing our time horizon focus to shrink dramatically. A fearful focus on today makes it difficult to stick with long-term investment strategies.
To avoid falling into the bad news panic, tune out the source of your overstimulation. Don’t track every up and down of the market. Resist checking your portfolio online. Checking your portfolio repeatedly does not benefit performance and often creates anxiety and panic. Making snap decisions when in panic mode can dramatically impact your ability to achieve long-term goals.
Another ancient survival skill that often trips us up when investing is our instinct to watch what others are doing and imitate them. Don’t just follow the crowd, assuming that others know something that you don’t. Instead of automatically following the herd, look for ways to leverage market reactions.
Our innate need to find and interpret patterns can also lead to trouble. Remember, past performance is no guarantee of future returns. Because of the constantly changing market, it is impossible to accurately predict the future. In spite of this, investors are constantly searching for patterns or trends that are repeatable.
We also tend to stick with what we know, finding comfort in the familiar. This tendency can lead investors to only consider stocks that they know or giving the assets the already hold a greater value. Investors can become attached to assets, holding them well past their benefit.
Four Ways To Avoid Emotional Investing
In summary, there are four important points to remember when investing that will help keep your emotions in check and prevent them from damaging your portfolio’s performance:
Focus on the big investment picture, by establishing goals and objectives prior to investing. Determine your investment horizon, so that you have adequate time to recoup losses and achieve your goals even if your portfolio dips down.
Develop a detailed Investment Policy Statement (IPS). In your IPS define your strategies of when to buy and when to sell.
Do your homework and know what you are buying. Know the risks inherent in the investment and how it fits into your IPS.