We all fondly believe that we are sensible and rational people, especially when it comes to managing our money.
However, psychology has observed that humans are imperfect information processors subject to bias, error and perceptual illusions. This becomes more than an interesting scientific observation when it affects the way we make our investment decisions and put our wealth at stake.
At Continuum, we are looking at three ways that psychological factors can affect investment.
We follow the herd
Standard financial theory states that investors make rational decisions and that markets are efficient, reflecting that rationality.
However, it has been demonstrated many times that emotional factors get in the way of rational decisions. The dot com boom of the late 1990s could be seen as an irrationally enthusiastic response to a new and only partly understood new technology. The soaring prices of Internet start-ups encouraged investors to pour money into any company with a “.com” in its business plan. It burst with expensive results as all bubbles do.
In hindsight, the dot com boom can be seen as demonstrating the first of the key problems of investor psychology, the tendency to follow the herd. As humans, we have an inbuilt tendency to mimic the actions of a larger group, because we find it hard to believe that the majority could be wrong. The reality is that investments can easily become overvalued due to this overoptimism.
Investors following the flock and making decisions without having enough practical knowledge can happen at any time. It’s painful to see others getting rich quick when we don’t, so when any particular sector starts to boom, we want to jump on the bandwagon – forgetting to ensure that we invest in businesses with underlying value.
The second problem is that as humans we can be prey to fear, which can turn into panic. We know logically that investment must be a long game, but another emotional factor can come into play, and we try to estimate future probabilities based on recent outcomes instead of long-term experience. This recency bias means we place more importance on the most recent events. In times of volatility when our portfolio values are plummeting, it’s difficult for us to remember that over the longer term, equity markets go up despite being hit by crisis from time to time.
When we experience a significant event such as the COVID crisis, we might fear the worst and believe that markets will continue to drop indefinitely. On some primitive level we fear huge losses and the end of the investment world as we know it. This may make us panic and sell investments, crystalising the losses, rather than simply waiting for markets to recover.
We worry too much about loss
Finally, human psychology is wired to feeling the effect of a loss much more than a gain.
Logically, we know that investment will be a rollercoaster, with downs as well as ups, but the fear of losing what we already have can be out of all proportion to the real threat. This is known as ‘loss aversion’ by both psychologists and economists. Losses during a severe market downturn can result in some investors trying to avoid risk at any cost and switching to very low risk holdings. This reduces the volatility and avoids losses, but it will mean missing out on opportunities and can result in falling well short of their long-term objectives.
So, what can you do?
We are all only human and it is impossible to escape our emotions, biases and fears completely. However, by understanding that we are all subject to cognitive biases, we can start reducing the errors and costs associated with them.
We can take practical steps, with a well-diversified portfolio. We need to avoid panic if things don’t seem to be going well, and irrational optimism when they do. We also need the support of a financial expert to help establish an investment plan based on sound principles, and our own objectives, timelines and tolerance for risk.
At Continuum our experts can combine a thorough understanding of the basics with a watch on the market. It means that we can help you plan the style of investment portfolio you need and help you keep it current and performing as it should.
As well as applying their professional expertise and experience to help you achieve your investment objectives, your adviser will take an objective view of the long-term plan they have put in place for you, which will prove invaluable when your emotions try to take over.
To find out more, simply call us.
The information contained in this article is based on the opinion of Continuum and does not constitute financial advice or a recommendation to suitable investment product or strategy, you should seek independent financial advice before embarking on any course of action.
The value of an investment can go down as well as up. Past performance is not a guide to future performance.
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