GROWING WEALTH PORTFOLIO

Emotional investing bad for your wealth

Emotions can be a great asset in life, but when it comes to investing, they are a liability.

In Summary

• A key trait all successful investors have is keeping emotions out of investment decisions.

• How an investor reacts to the market cycle determines market losers and winners.

An investor looks at the digital board at the Nairobi Stock Exchange.
An investor looks at the digital board at the Nairobi Stock Exchange.
Image: FILE

Investors are subconsciously prone to behavioural biases that influence their investment decisions and majority to negative results. The effect of emotions in investing has for long been an ignored area that leads to disastrous investment performance and also explains some of the swings witnessed in the market.

A key common trait that all successful investors have is keeping their emotions out of their investment decisions. The manner in which an investor reacts to the market cycle determines market losers and winners.

Investment fluctuation has always brought forth two sides to investment that often prompt an emotional reaction or indifference - when markets decline and when markets climb. When markets are climbing, emotional investors become excited and overconfident, thus willing to take on additional risk to see their assets grow further.

When markets are declining and investments decrease in value, the same category of investors become anxious and worry about what impact the decline will have on their overall financial welfare and often sell off. All of these emotions are entirely understandable but reacting on such bases can be detrimental to reaching investment goals.

Investing therefore is not typically a get-rich-quick tactic that one can do on short-term and expect to make steady significant profits. It is often a long-term process filled with patience, commitment, and keeping calm when the market fluctuates that reigns.

Left unchecked, emotions can lead to myopic investment decisions. Therefore one main skill every aspiring or practising investor has to master and understand is their behavioural biases as they influence their investment decisions and behaviour.

Many investors will never overcome their intrinsic emotional biases and should curb that by understanding the range of emotions they may experience and how they affect their interactions within the market.

There are four main biases that most investors will suffer from. These are confirmation bias, overconfidence bias, illusion of control bias and hindsight bias.

Overconfidence is an unrealistic view of oneself and one’s performance. It causes investors to misinterpret their skill and the information they have. The excitement sweeps them away following a relish of early profitability that causes them to consider what more the market success could allow them to amass.

The brief success clouds investor sobriety from which they self-upgrade to investment commentators. This is called the house money effect, which means investors are willing to take more risk with previous gains than their initial capital.

In that hysteria, investors begin to ignore risks and expect every investment move to become profitable, thereby marking the peak of financial risk. But in an unexpected twist of events, the market moves against the odds from which they convince themselves that they are long-term investors and that all their ideas will eventually work, and they enter into the illusion of control bias.

 

However, when markets fail to rebound, they are left with no turn-around strategy, forcing them to deny ever making poor choices. But deep down, not knowing how to act, they fruitlessly grasp at any idea that supports the set of beliefs and information they already have. This is called the confirmation bias.

Having decided their assets will never increase again, they exit the markets to avoid any future losses vowing never to trade again. In regret, they are left trying to understand their actions. Eventually, they return to the realisation that markets move in cycles, and begin looking for their next opportunity where they run the risk of investing again but now on hindsight bias.

After purchasing an asset that turned profitable, these victims renew their faith that there is a future in investing. They are back to exactly where they began to either repeat the same mistakes or ready to overcome emotional biases in order to increase financial success.

Whereas it is difficult for investors to watch the value of their portfolio decline, it is tougher to recover from a series of poorly timed decisions. Controlling emotions, staying calm during all market environments and remaining consistent is critical for investors to reach their financial goals.

One way to reduce the emotional impact of market volatility is having goal investment. The market tends to be more volatile over shorter time periods. Investing therefore is not typically a get-rich-quick tactic that one can do on short-term and expect to make steady significant profits. It is often a long-term process filled with patience, commitment, and keeping calm when the market fluctuates that reigns.

Many advisers have been through multiple market cycles and have seen difficult periods before. Having an objective adviser who can share their expertise and experience and provide advice during difficult times can be extremely important in keeping the investment plan on track.

In many cases, working with a financial adviser makes sense, but it is possible for investors to be their own financial advisers too if they are willing to put in some time and effort to evaluate their financial decisions.

Emotions can be a great asset in life, but when it comes to investing, they are a liability. Potential and budding investors have to remain vigilant in order to avoid or to break the cycle of investor emotions.

Chief investment officer, Amana Capital Limited.