Investing can be an emotional roller coaster. Ask anyone who peeked at their portfolio balance in March 2020, or April 2009, or the better part of the first two years of this century.
When investing, and no matter your net worth, you’re going to have emotional responses. But they don’t need to (and shouldn’t) dictate the decisions you make along the way. Emotional investing is what happens when you succumb to your impulses and overreact to market gyrations, rather than to an analysis of the fundamentals.
Investing that is driven by emotion – greed or fear, for instance – often becomes a self-destructive exercise in bad market timing: buying at market highs and selling at market lows.
So, how can we avoid emotional investing and keep ourselves on track?
First, let’s look at some drivers of emotional investing. By recognizing our innate biases (we all have them), we can find ways to manage them.
Herd mentality: This is essentially the desire, conscious or otherwise, to copy what other investors are doing. It is also one of biggest contributors to investment bubbles and mania. In our age of mass information, social media and the fear of missing out (also known as FOMO), the potential power of herd mentality is only likely to grow stronger.
Anchoring: This bias occurs when an individual’s decisions are influenced by a particular reference point, or “anchor.” It is a belief typically based on the first piece of information found – which may or may not be relevant to the decision-making process. An example of anchoring would be observing a large stock price decline and concluding that the stock is now “cheap” by virtue of the decline alone.
Hindsight bias: We often believe that after an event has occurred, we would have predicted or even known the outcome of the event before it occurred. Also aptly named the “knew it all along” phenomenon, that’s hindsight bias in a nutshell: the tendency to view past events as more predictable than they actually were and then erroneously believe we could have had more control over them than was reality.
Fading affect and egocentric bias: We’ve all been at a cocktail party and heard friends or family talk about how much money they made on an investment. Funny how we never hear about any of their losses… These two concepts related to hindsight bias describe this “selective memory” tendency to forget our mistakes and overemphasize our wins.
Greater fool theory: Those under the spell of this bias have a perceived ability to buy and sell a stock quickly enough to profit off a “greater fool” – aka the next person rushing in. Fundamentals are thrown out the window as this becomes a game of pure momentum, with someone ultimately left holding the bag when prices come back to earth.
Letting these biases overtake your investment strategy often leads to underperformance – and the current environment is particularly fraught. With trillions of dollars being pumped into financial systems around the world, low returns available in bond markets, and a sense of hubris from the astronomical stock market gains coming out of the short-lived COVID-19 crash, investor appetite for risk-taking is high and speculative pockets are emerging. A few examples are cryptocurrencies (Bitcoin, Ethereum, Dogecoin), Robinhood/meme stocks and special purpose acquisition companies (SPACs).
What is an investor to do?
Now let’s take a look at what you can do to ensure these biases don’t negatively affect your investment returns.
Subdue your biases: Simply being aware of the above emotional biases is a great starting point.
Stick to your investment plan: If you don’t have a plan in place, you should (see this article for more on the value of investment plans). This is an excellent way to avoid the sway of emotional investing, as the plan will have been devised when your emotions were in check. Then when markets head south, you can ask yourself questions like:
- Are my investment goals the same as they were before the current market decline?
- Am I appropriately diversified?
- Has my time horizon or financial situation changed?
- Do I have the appropriate level of risk in my portfolio?
Stick to your investment discipline: Whether you’re a value investor or a growth investor or somewhere in between, stick to your discipline and don’t let it be pulled by short-term market fluctuations or cocktail party talk. If you are tempted to jump into something speculative or without doing your research first, make sure to allocate only a prudent percentage of your investable assets and be prepared to lose it (or a portion of it). Also recognize it for what it is – speculating, not investing!
Diversify: Portfolio diversification helps smooth returns over time. It is a risk management technique that ensures your portfolio is made up of a variety of asset classes, and includes securities from various geographies, sectors and industries. Different market conditions favour different types of investments, so a well-diversified portfolio should provide protection through a variety of market conditions as losses in some investments will be offset by gains in others.
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Easier said than done
Investing without emotion is easier said than done (most things that are worthwhile are!). Being aware of your own biases should give you pause. Developing a plan that incorporates your own risk tolerance and the risks of your investments will prevent you from chasing unachievable gains or overselling in panic situations.
Sticking to your plan and staying the course through market volatility gives you the best shot at superior long-term performance – the ultimate goal!
Leanne Scott, CFA, provides discretionary portfolio management for foundations and wealthy individuals and their families with Leith Wheeler Investment Counsel in Vancouver. With more than 20 years of investment industry experience both in Canada and the UK, Leanne also holds an MBA and the Chartered Financial Analyst (CFA) charter.