DIY investing: How to avoid emotional investing
Emotion is often quoted as being the enemy of reason with investors being encouraged to check their emotions at the door when they trade the stock market.
However, when hard earned capital is at risk, is that advice realistic?
Perhaps it is more important that we simply acknowledge our emotions, rather than ignore them. By understanding what motivates us when we invest we can avoid falling into some familiar traps and as a result become more disciplined and profitable investors.
‘Nobody ever lost money taking a profit’
Behavioural finance is, in academic terms, a relatively new subject that only got off the ground in earnest in the 1950s.
A big breakthrough moment came in 1979 with the publication of Prospect Theory: An Analysis of Decision Under Risk – a paper by psychologists Amos Tversky and Daniel Kahneman. It argued that losses have more emotional impact than an equivalent gain.
Behavioural finance A to Z
There are a number of core theories which underpin behavioural finance. They include:
Anchoring – becoming fixed on previous information and using that information to make investment decisions that are no longer appropriate.
A good example might be continuing to buy a company which has historically delivered earnings upgrades through a cycle of profit warnings.
Jet engine maker Rolls-Royce had historically outperformed expectations but then went off the rails, delivering a string of profit warnings from February 2014 onwards.
Confirmation bias – allowing your preconceived opinion to drive your analysis of an investment.
If you have heard the buzz about a particular biotech stock you might, for example, choose to conduct your research to prove its potential is real rather than seek to challenge the ‘buzz’ claims.
A better approach would be to consider the reasons for not making an investment and then go through them one by one to see if they can be eliminated.
Herd behaviour – the tendency to follow the actions of a larger group of investors perhaps because you think they must know something you don’t.
During the dotcom boom people frantically put huge amounts of money into internet-related stocks even though they often had no track record of cash flow, profits or sometimes even revenue.
Overconfidence – the belief that you are better than others at choosing the best stocks.
This might translate into frequent trading as you look to enter or exit the markets at the best possible time, potentially missing out gains from being constantly invested over the long-term.
Prospect theory – a loss hurts more than any pleasure you take from an equivalent gain.
This could prevent you from running a winning position long enough but more damagingly could see you hold on to a position because you cannot face the ‘prospect’ of crystallising a loss.
‘Nobody ever lost money taking a profit’ is a famous phrase by American businessman Bernard Baruch. Selling a stock too early may be frustrating, but no one should ever have long-lasting regrets if they sold for a profit.
Charting your emotions
The emotional journey investors go through at different points in a stock market cycle or when investing in an individual stock is relatively easy to chart.
To begin with ‘hope’ dominates before firming into ‘optimism’ and then potentially ‘excitement’ if corporate earnings arrive ahead of expectations.
This can move to ‘thrill’ and ‘euphoria’, particularly if investing in shares becomes a mainstream topic. This is almost certainly the point of greatest risk.
‘In order to be a better investor you need to identify and overcome your psychological weaknesses’
Famously Joseph P. Kennedy, father of US president John F. Kennedy, sold all the stocks he owned just before the 1929 Wall Street Crash after a bellboy in a hotel began offering him stock tips.
He decided if the bellboy was buying stock then it would be difficult to find someone who was below this lowly position to buy shares and keep the stock market momentum going.
At this stage investors are not focused on the possibility of losing money or the fundamentals behind a stock and instead fret about missing out on a potential opportunity.
Any bit of news at this point which falls short of these inflated expectations can act as the trigger for a correction.
Investors will then go through the more negative emotional stages of ‘anxiety’, ‘denial’, ‘fear’, ‘desperation’, ‘panic’, ‘capitulation’, ‘despondency’ and ‘depression’.
Being aware of emotions and identifying your own weaknesses can mean the difference between profit and loss for your investments. In order to be a better investor you need to identify and overcome your psychological weaknesses. One thing is guaranteed, we all have them.
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By Tom Sieber