As human beings, we tend to react on our instinct and emotions when making decisions – particularly when things go wrong.
While in some situations this type of response can prove useful, when it comes to your investments it can be more of a hindrance. That’s because when our emotions take over, it’s harder to think logically – which may lead us to make hasty, short-term judgements that negatively impact on our long-term financial future.
Our emotional-driven biases
Many of us react differently to market volatility. We often use a number of emotional biases when making investment decisions – and most of the time, we don’t even realise we’re using them.
Understanding each bias can help you develop ways to control them, invest more logically – and achieve your ultimate financial goals.
1. Following the crowd
We can often think that, just because everyone else is going in a certain direction, this must be the correct route.
It isn’t. In fact, thinking this way can be a dangerous approach. Investing should always be about what’s right for your unique circumstances – not the herd. Often, a fund which has performed well after a certain period generates positive attention – and encourages people to invest. But just because it’s been successful one year doesn’t mean it will be the next.
2. Gain/loss aversion bias
For some investors, feeling unhappy about making a loss from their investments can outweigh the delight they feel from a gain.
This can influence their decisions. If a fund is experiencing a positive run of performance, they may be tempted to sell it too soon believing a loss may be around the corner. Yet even if markets did fall, they could miss out on potential long-term goals when markets go on to recover.
3. Anchoring bias
As economic and market conditions are shifting all the time, investors sometimes make the mistake of clinging onto a belief – even if it becomes out-of-date.
Take, for example, the credit crunch crisis of 2007-09 when markets fell significantly. In the aftermath, some investors may have formed the opinion that shares were too risky – and therefore steered clear of them. However, in the years that followed the recession, markets did in fact improve – and this positive period for shares continued far longer than the original decline.
4. Optimism bias
During good market periods, some investors can mistakenly become over-optimistic, assuming this trend will continue. Alternatively, they may switch to extreme pessimism during downturns, believing there isn’t a light at the end of the tunnel.
Past performance is never a guide to future returns, but history has proven markets tend to go in cycles. It’s important to remember that strong stock market runs don’t last forever, and at some stage momentum may start to slow- and vice versa.
5. Regret aversion bias
This is fear of regretting the decisions you make – leading you to play it safe and possibly avoiding investing altogether. You may even prefer to follow the crowd, with the mentality of ‘if this turns out to be wrong, at least I’m not on my own.’
Ironically, this way of thinking could lead you to subconsciously make the wrong choices – and miss out on opportunities that leave you feeling an even greater sense of regret.
Ways to manage your emotions when investing
- Take your time before making a decision. This can help you resolve any emotions you feel at first – before adopting a more rational outlook.
- Understand that market fluctuations are all part and parcel of investing.
- Stay focused on the bigger picture/your personal long-term financial goals. Not the short-term blips.
- Remind yourself that you can’t predict market movements. No one can.
- Speak to a financial adviser.
Whatever markets throw at you, we’re always here to provide extra reassurance, guidance and an objective view.
Our investment recommendations are likely to include stock market-linked investments. These aren’t like building society savings accounts, as your capital is at risk and you may get back less than you invest. The value of your investments and any income from them may fall as well as rise.