Understanding your emotions can make you a better investor

At a glance

  • Even the most level-headed investor can find themselves swept up in the inevitable ups and downs of markets.
  • Understanding our emotional responses to money can lead to better financial decision making.
  • If you’d like to know more about how to make better investment decisions, get in touch.

In this article, we look at the four most common emotional responses triggered by money – and how you can manage them.

Everyone is prone to letting their heart rule their head on occasion. But if you want to be a better investor, leave your emotions at the door.

Why is investing an emotional process?

Even the most level-headed investor will sometimes find themselves being swept up by the inevitable ups and downs of markets. We love the adrenalin rush of the ‘up’ – but a sudden downturn can feel like having the rug pulled from under your feet.

Understanding the psychology that underpins our investing patterns can help you take the emotion out of money – and make better decisions.

How our brains are adapted to respond to threat and opportunity

Part of the explanation of why we feel the way we do about our finances comes down to evolution. Our brain is well-adapted to respond to the threats we faced hundreds of thousands of years ago. Survival was often based on immediate physical or physiological responses to a sudden change in our situation – so called, ‘fight or flight responses’. But we live in a different era, and those same instincts which kept us alive millennia ago, may lead us to make some poor decisions.

The behavioural finance expert, Dr. Daniel Crosby describes it as asking a 150,000 year old brain to navigate 400 year-old financial markets. Crosby identifies four common ‘mistakes’ or biases that can compromise our thought processes – over-confidence or ego, emotion, attention and conservatism.

Being over-confident

We have a natural tendency to overestimate our skills, whether we’re changing a tyre or managing our finances. In investing, overconfidence can lead to people overestimating their understanding of the stock market or specific investments. This may result in less experienced investors trying to second-guess or ‘time the market’, or to invest heavily in riskier funds. Over-confidence can leave you over-exposed and under-diversified.

All investment carries a degree of risk, and understanding your own attitude to risk is a fundamental part of all financial planning. Financial advisers and professional fund managers have a significant advantage – they’re trained to understand the impact of our natural biases and can work to mitigate the risks. Part of that risk management is spreading your investments across a wide range of expertly managed funds, rather than investing significantly in just a few.

Letting feelings cloud your judgement

Your emotional state of mind can dramatically influence the way that you see the world. And it can impact on your ability to judge risk against reward. So, someone in a buoyant mood might underestimate risk. People often become more optimistic and self-confident when markets rise, only to panic when they fall.

Avoiding the risk of over-reacting – whether that’s buying in or selling up –is key to long-term investment success. The best thing you, as an investor, can do is to know yourself, and be ready to manage your emotions as markets ebb and flow.

Taking a step back, and calling on expert advice or a second opinion can be invaluable. It is far easier for someone else to see when we are acting emotionally, than it is to see it in ourselves.

If you’re going through any extreme emotions, whether positive or negative, it’s a good idea to avoid acting on those feelings. Personal financial advice can help you to contextualise what you’re going through, and whether your feelings are affecting your judgment.

It can help not to track the FTSE 100 slavishly every day; watching every rise and fall, will Inevitably provoke our emotions. Instead, It Is far better to stick with a prudent Investment plan, which will often Involve making regular contributions.

Reacting to short-term noise

Reacting or over-reacting to short-term noise is what psychologists call ‘attention’. We focus too much on what’s happening in our immediate present and take our eyes off our long-term goals. As investors, it can be all too tempting to react to events as they happen. We’re hard-wired to respond to what Is right before our eyes.

As investors, the answer is to try and avoid reacting to short-term events. The best investors don’t try to time the market by responding to every news headline and market turn. Regularly meeting with a financial adviser can help you stick to your plan.

Playing it too safe

In the past, there could be an evolutionary advantage in ‘playing it safe’ – or being conservative. But investing is also about managing opportunity as well as managing risk. Psychologists call this ‘loss aversion’. We’re over twice as upset by a loss as we are about a gain. Rather like an actor only remembering the bad reviews. It’s another psychological bias to recognise in yourself.

Playing it too safe could lead you to avoid less familiar investment options and taking less investment risk than you should. We need to focus on selecting Investments that are best aligned with our long-term goals, which often means coping with some painful short-term volatility.

If a fear of short-term losses dominates your Investment decision making this could cost you real money if you’re not putting your money where it could achieve the best results.

Financial advisers understand these emotions very well, and can help you manage both your feelings, and your finances when portfolios are down, as well as when they’re up.

Use your emotions to make better investment decisions

It’s not about taking the emotions out of investing – we’re emotional beings, not robots. But successful investing is about being honest about your emotions and then filtering them out before making any rash financial decisions.

Just as we seek out the advice of people we trust when we’re going through an emotional time, seeking the support of a financial adviser who’s one step removed from the situation, can be a real help.

Speak to us today about making better investment decisions.

The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.

SJP Approved 21/02/2024

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