Impact of emotions on investments

What you’ll learn:

• How our emotions are often the biggest driver of our investment decisions.
• What emotional investing could cost you.
• How you can achieve potentially better results by sticking to a long-term investment plan.

The cost of being human

Humans are by nature emotional creatures, so it’s perfectly natural to feel a sense of panic, or to want out, when you see the funds or investments you have put money into fall in value, and a sense of excitement when they are rising in value.

Depending on how markets are performing, it’s also common to decide to leave large sums un-invested because you are worried about losing money, or to be overconfident and overactive with any portion of your wealth you do invest. The way our emotions change with the market cycle is why so many of us decide to invest when markets are performing well and to sell our investments when markets are falling.

All these emotional reactions deviate from good investing practice, where you stick to the following four main principles:

• Put your wealth to work (being invested)
• Diversify to reduce risk (spreading your risk across markets, asset classes, geographies and industries)
• Ensure you have sufficient liquidity to withstand the journey (avoiding being forced to sell at a time not of your choosing) and
• Rebalance (selling asset classes that have risen in value, and purchase those that have fallen, in order to continually buy low, and sell high over time).

The true cost of emotional investing

Our need to feel emotionally comfortable when we invest can be quite costly in foregone returns. A study from Cass Business School estimated the foregone returns at 1.2% per year, and the annual DALBAR survey of US stock market investor behaviour frequently estimates a penalty of 3-4% per year. Staying invested can be tough and the financial decisions, which are likely to benefit us over the long-term can be very uncomfortable to live with in the short-term.

Investors therefore need to focus on the best ‘anxiety-adjusted’ returns they can achieve. These are the best possible returns, relative to the anxiety, discomfort and stress they are going to have to endure over their investment journey - or to put it another way, investors want the best possible long term returns and also sleep well at night.

Stick to a long-term plan

The longer you’re prepared to stay invested, the greater the chance your investments will yield positive returns. That means holding your investments for at least five years, but preferably much longer. Whatever short-term setbacks you might be confronted with stay focused on the bigger picture and try not to be distracted by the daily performance of individual investments.

Find out more about the significance of spending time in the market

If you are tempted to sell during periods of stock market volatility, think about the reasons why you picked your investments in the first place. It can be a good idea to write down your rationale for why you chose particular investments before you buy them, so that you can refer back to this when you are experiencing a ‘wobble’. Keeping a trade journal is a tool used by many professional investment managers to help regulate the emotions of staying invested.

Try not to ‘over-monitor’ your investments either. It is important to keep track of how your investments are performing but if you are investing for the long term, reviewing your portfolio once or twice a year should be adequate. Receiving information too often can make you perceive more risk than you really face and spur you on to make decisions you may not otherwise make.

You need to bear in mind though that no matter how you control your emotions, your investments can still fall in value and you might get back less than you invest