Getting too attached to an investment can put potential returns at risk
Being aware of emotional biases is crucial for experienced investors. Social psychologist, Joseph P. Forgas, said the more complex the choice is, and the more uncertain the subject, the easier emotions can influence a decision.
Emotions can be a powerful tool to navigate the world. At a basic level they help us survive, but they also have the capacity to elicit strong impulses – and using emotions to guide investment decisions can leave inexperienced investors in risky territory.
Emotional bias
Developing attachments to assets and colouring them with sentimental value, also known as ‘ego-involvement’ can result in investors identifying with their investment choice. Should it lose value, it can also lead to a refusal to divest in the hope it turns round.
Other emotional biases also exist, and they can affect the way an investor views their holding. For investors looking to build a resilient portfolio, acknowledging the existence of emotional bias is key if they want to remain somewhat objective and potentially protect returns.
Loss-aversion bias, for example, is associated with pleasure and pain. The pain felt when a loss is incurred from an emotionally charged investment is far greater than the pleasure it provides from gaining value.
Overconfidence bias, meanwhile, is a situation in which the investor holds the belief that they are better than they are – an overestimation of their skills. This can very easily lead to significant losses.
Another is endowment bias, which relates to an individual’s valuation of a stock. The valuation is higher than is warranted and often irrational and can blind an investor to potentially better opportunities within the same sector.
According to Oxford Risk, investors lose an average of 3% a year in returns to emotionally driven investment decisions. In part, this can be attributed to times of market volatility when those investing based on emotions rather than fundamentals tend to buy high and sell low.
For others, the need to be a part of the latest investment trend or popular theme can push them into areas to which they have emotional connections. Environmental, social and governance (ESG) investing could well fall into this category.
ESG and emotions
Investing in a socially responsible way is naturally emotive, as it focuses more on an individual’s principles than other, more traditional strategies do. However, the industry has moved on from simple screening and ‘bad’ stock exclusion, with heavy analytics and research-driven processes now driving sustainable investments.
Facts trump instincts
The best investors are not emotionally tied to their investments and instead base their decisions on fact rather than instinct. They systematically search for the best investment opportunities available, analyse their position in the wider market and research the stock’s fundamentals before parting with a penny.
Selling only happens when it makes sense – has what made the investment attractive changed, for example? Emotionally charged selling tends to be related to fear, more specifically when the market is falling – a company with strong fundamental elements can often bounce back from a wider market fall.
A 2018 study published in the Journal of Financial Planning found that investors who use a behaviour-modified approach to investing which removed emotion generated returns up to 23% higher over 10 years.
For clients looking to preserve and compound their wealth over the long term, an experienced wealth manager such as London and Capital can help, thanks to our thorough understanding of wider investment markets.
A resilient portfolio requires a tailored investment strategy that is based on the individual financial goals of an investor. While a wealth plan can consist of ambitious dreams and aspirations, building a portfolio with the intention to preserve wealth over the long-term means leaving instincts and emotions at the door.
