Our emotions can often dictate many of the decisions we make in our daily lives. So how do they affect our choices in the investment process?
Emotions in the investment process
For many investors, it can be hard to separate emotion from the investment decision-making process. That’s understandable, given that many are managing nest eggs which they’ve patiently built up over years and which they have earmarked for important future events, such as retirement, or to pass on to a family member to help with an important purchase.
Emotion can often hinder the process rather than help it, but sticking to some simple rules can help, especially when it comes to underperforming investments.
A lot of research has gone into analysing the pros and cons of different types of investment behaviour, but really it comes down to head versus heart. While there's no silver bullet, there are some rules you could use to be less irrational as an investor, and gain more from the experience.
A number of books have been published exploring how we behave with our finances – an area now known as behavioural finance. This field looks at the ways in which psychological and emotional influences affect our investment decisions, such as when to buy or sell. The research delves deeper and more meaningfully into the issues, but ultimately it boils down to simple logic versus emotion.
Many investors might benefit from asking themselves how often they’ve made an impulsive investment decision and lived to regret it. And more importantly, how often have they done that, but learnt from it and never made the same mistake again?
Regrettably, we sometimes fall into the same trap more than once, but these are the lessons which are so vital in helping us to become more successful at investing. Not being afraid to admit a mistake, and learning from those we do make, is the path to more enjoyable and potentially financially-rewarding investment.
A disciplined approach
A question which is often asked at our presentations is: “When should I take profit, and how do I determine whether it’s the right time to do so?” While there isn’t a simple golden rule that works for every investor, it is possible to set some general ground rules.
It’s often useful to approach the profit-taking question from the opposite side and ask: how much money am I prepared to lose from my investment? This is the part of the investment psyche which can often bring emotions to the fore.
For example, if I invested £1000, I might be prepared to lose a maximum of 20% (£200), as the thought of anything greater is too much to tolerate. It could be argued that this means I’m adopting a rational approach.
On the other hand, why would I not start to take profits when my investment has returned 20%? Some investors will, but there are a significant number who experience the euphoria of their investment growing larger and larger and are suddenly turned into an irrational investor – visions of an ever-bigger return flash before their eyes.
Quite simply, when we fear a loss most of us are far more rational and objective, whereas when we are in profit and enjoying that feeling of success, we never want it to stop and are therefore less likely to stop it ourselves.
It must be said that sometimes investors are not always rational when stocks go down. They sometimes persuade themselves to hold on for a variety of reasons that often reflect their emotional attachment to the stock more than any sensible reasoning: “The fall is just a blip”, “there doesn’t appear to be any reason for it”, or “it must surely recover given enough time” and so on. Similarly, when investors hold shares in their own company, they can be tempted into a false sense of security and more reluctant to sell if they go down, due to a feeling that they know the company.
It’s worth bearing in mind the way the big institutional investors, such as pension funds and insurance companies, make decisions about their investments in the market. They focus very largely on fundamental data, looking mainly at valuation methods, comparing their investments with other similar companies or funds and taking future prospects into account.
That process is done on a regular basis, and decisions are often guided by factors such as limits on how much they can hold in certain asset types and regions. The result is that emotion rarely plays much part in their decision-making.
While few individual investors have the systems and expertise to follow this approach, either of the following strategies could be adopted to help ensure profits are banked:
- When an investment reaches a pre-determined level of gain, e.g. 20%, simply take the profit and then either bank it or invest it into another new investment idea. This subsequent investment is, theoretically, a free investment as it hasn’t cost you anything.
- When the investment gains by a pre-determined level, let’s say 20% again, withdraw the original investment sum leaving the profit to become a free investment in your original idea. You then have the peace of mind of knowing that you have your original investment stake intact.
Neither of these strategies are rocket science, but when calmly and simply set out, they make sense and help avoid unnecessary anguish and disappointment.
Even the very best professional investors cannot always time the top or bottom of the market, but many of us could benefit from adopting their mindset of being fairly disciplined when it comes to selling, and resisting the tendency to become emotionally attached to investments.
All information given including prices, yields and our opinion is correct at the time of publication. Our opinions on investments can change at any time and for our latest view please go to www.share.com. To understand how our Investment research team arrive at their views please read our Investment Research Policy.