Investing, inherently emotional, can lead even the most composed investor on a rollercoaster ride through market fluctuations. Understanding this emotional ebb and flow is pivotal for sound, long-term wealth growth. Recognizing the common pitfalls ingrained in human psychology equips you to make more informed decisions and navigate the unpredictable financial landscape with resilience.
Dr. Daniel Crosby sheds light on the evolutionary aspect of our brains, finely tuned for challenges long gone. However, in today's financial realm, these ancient instincts can sometimes lead us astray.
"Our brains were formed to protect us from a different time and place than the one we find ourselves in today. We've got 150,000-year-old brains, with which we are trying to navigate 400-year-old financial markets," he emphasises.
Crosby identifies four prevalent biases—ego, emotion, attention, and conservatism—that often guide our financial choices. Understanding and acknowledging these biases become the compass for steering through the complexities of financial decision-making.
1. Over-confidence (Ego)
Many people tend to overestimate their abilities, be it changing a tyre or handling personal finances. When it comes to investing, this overconfidence often makes people believe they understand the stock market or certain investments better than they do. This can lead to not-so-smart moves, like trying to predict when the market will go up or putting too much money into risky things.
Professional fund managers have a big advantage—they're trained to understand these kinds of mistakes and can try to avoid them. That's why it usually makes more sense to spread your investments across a wide range of different funds that experts manage.
2. Allowing emotions to cloud your judgement
We all have a natural inclination to let our emotions shape how we perceive risk and reward, impacting our decision-making. Your mood significantly influences how you view the world; when in a great mood, risks may seem less apparent, while a bad mood can magnify them. People often become more optimistic during market highs, only to succumb to fear and panic during downturns.
Successfully navigating long-term investments involves avoiding the pitfalls of overreacting. Knowing yourself and managing emotions during market fluctuations is crucial. If you're feeling very emotional, whether it be greed, fear, or anything in between, it's probably best not to make big decisions. And getting advice from a financial expert can help you understand what you're going through. Plus, setting up a regular monthly payment into your plan can help take some of the emotions out of investing.
3. Reacting to short-term noise (“Attention”)
"Nothing in life is as important as you think it is while you are thinking about it," wisely noted psychologist and economist Daniel Kahneman. As investors, it's tempting to react hastily to unfolding events, as our brains are wired to emphasise the vividness of an event over its likelihood.
Take shark attacks, for instance, vividly portrayed in movies like Jaws. Despite their on-screen notoriety, they're remarkably rare. On the contrary, more prevalent but less sensational risks like heart disease are often underestimated.
The key for investors is to resist reacting impulsively to short-term events. Successful investors don't attempt to time the market based on short-term forecasts; they understand that uncertainty is inherent in their profession. They adhere to long-term principles, steering away from the thrill of reacting to every news headline. Regular consultations with a financial adviser provide valuable guidance in maintaining focus on long-term goals.
4. Playing it too safe (“Conservatism”)
Our instinct for safety is deeply ingrained – a survival mechanism from our ancestors navigating scarce resources. However, in today's context, this conservatism might make you shy away from less familiar investment avenues, potentially hindering your ability to take the necessary risks for optimal returns. Over a lifetime, this cautious approach could translate into substantial financial losses.
This 'conservatism' is essentially an asymmetrical response to loss versus gain. Research indicates that losses weigh on us about two-and-a-half times more heavily than gains of a similar magnitude. This psychological phenomenon is evident in everyday scenarios, such as a gambler feeling much worse about losing $100 than winning the same amount.
In the realm of investing, this tendency plays out too. Advisors often receive more disgruntled calls when portfolios dip by 20% than appreciative letters during prosperous times.
Remaining steadfast in an investment, regardless of its performance, can be as detrimental as not investing at all. If you choose to hold, it's crucial to do so with a clear rationale, keeping an open mind to alternatives, and regularly reassessing your portfolio in consultation with your financial adviser.
If you’d like to know more about how to make better investment decisions, then speaking to aSt. James'sPlace Partner is a good place to start. They will guide you and ensure that you make the right decisions, ensuring your long-term financial wellbeing.
