How emotions can impact your investment decisions
15:11, 17 January 2022
The trading pits of the city were notorious for running on high emotions. Traders were constantly shouting numbers at each other, always seemed on edge, and emotionally charged.
Of course, COVID-19 put an end to open outcry trading pits where it was typical to see traders in close contact, pushing and shoving.
Nowadays, trading can be done remotely from the comfort of your own home. But whether you’re a professional trader, just looking to take a punt, or if you’re investing long term the emotions are still there and they could play a big part in what we buy and sell.
It doesn’t really matter what emotional state you’re in. You could be happy or sad and still make bad investment decisions. But why can emotions be the enemy?
Selling in a panic
A common emotion we experience when trading or investing is panic. If share prices are tumbling, it’s hard not to get upset and sell to preserve what capital we have remaining.
But making an investment decision when you’re panicking will often end in tears. We recently witnessed the consequences of making panicked financial decisions at the beginning of the COVID-19 pandemic in March 2020.
“Many investors bailed out of the equity markets at the lows only to re-enter the markets after they had advanced significantly from the lows. Making panicked decisions results in investors selling low and buying high,” points out Robert Johnson, professor at Creighton University and CEO at Economic Index Associates.
Buying when you’re happy
It may not sound possible, but you can make the wrong decisions if you’re in a positive mood too.
Happiness is an emotion best harnessed when you need to engage in new projects or perhaps even to discover new potential investments. But before you put your money down, make sure it’s not based on the current bliss that you feel.
“While a healthy dose of optimism can certainly help, ideally you want to keep an even keel. You don’t want to ride too high or too low. After all, markets have no emotion about you, and you shouldn’t have emotions about them,” says Frank Murillo, partner and managing director of Snowden Lane Partners.
How can you take the emotions out?
It’s difficult keeping emotions at bay, but it’s not impossible. There are various strategies you can adopt to ensure you don’t make decisions when you’re at the mercy of your emotions. They include:
- Sticking to a plan
One way to keep the emotions out of your investment decision is to create a plan and stick to it. This should be based on an Investment Policy Statement (IPS).
Johnson explains: “An IPS is a written document that clearly sets out a client’s return objectives and risk tolerance over that client’s relevant time horizon, along with applicable constraints such as liquidity needs and tax circumstances.
“In essence, an IPS sets out the ground rules of the investment process – it is the document that guides the investment plan. Included in that IPS is a target asset allocation. The IPS should include a glide path for target asset allocation changes as the individual ages.
“All investors should have an IPS. And, it is best to develop an IPS in a rather calm market. Developing an IPS in a volatile market or during major stories is problematic.”
The point of an IPS is that it guides you through changing market conditions. The wrong thing to do, would be to alter it because of market fluctuations. Of course, it shouldn’t be set in stone.
Johnson adds: “It only needs to be revised when your individual circumstances change - perhaps a divorce or other unanticipated life change.”
- Work with a professional
If you make investment decisions alone it can be harder to keep your emotions at bay. However, consulting a professional financial advisor can help to ensure that you keep your emotions in check and remind you to stick to your IPS.
“Working with a trusted financial advisor can help you see extremes in a historical context and work through times when emotions tend to take over. Sticking with your investment plan in tough times and overcoming emotions is paramount to long-term success,” says Ryan Johnson, director of portfolio management and research for Buckingham Advisors.
- Getting in the ‘zone’
Many concur that the only state of making decisions is a flat state with no emotions. Marcus de Maria, CEO of Investment Mastery, says one way to get your head straight is to get into a routine.
“I know a Dutch trader who always walks with his dogs, then reads out his trading plan, turns on classical music, and is ready to trade for three to four hours that day. He might make 40 to 50 trades in that time. If he feels tired, he stops immediately. Tomorrow is always another day,” he says.