Investing can be an emotional process, and even the most level-headed investor will sometimes find themselves being swept up by the inevitable ups and downs of markets.
That’s why, when it comes to growing your wealth over the long term, one of the best ways to make better decisions is to understand the psychology behind investing. If you can spot the common mistakes that human psychology makes us prone to, then you’re more likely to make good decisions in the future and manage your emotions more successfully.
It all comes down to the evolution of the human brain, according to behavioural finance expert Dr Daniel Crosby. As he points out, our brains are well-adapted to the threats that we faced hundreds of thousands of years ago. But we now live in a different era, in which they can sometimes lead us to make poor decisions.
“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 adds.
He says that the most common mistakes (which psychologists call ‘biases’) can be grouped into four categories: ego, emotion, attention and conservatism.
1. Over-confidence (‘Ego’)
Many people overestimate their skills, whether it’s changing a tyre or managing their own finances. In investing, overconfidence often leads to people overestimating their understanding of the stock market or specific investments. This often results in ill-advised attempts to time the market or build concentrations in risky investments.
Professional fund managers have one significant advantage – they are trained to understand the impact of biases and can attempt to mitigate the risks. That’s why it’s generally better to spread your investments across a wide range of expertly managed funds.
2. Letting feelings cloud your judgement (‘Emotion’)
All of us have a tendency to let our feelings colour our judgments of risk and reward, and to influence our decision-making process. Basically, the mood you’re in dramatically influences the way that you see the world. So, someone in a great mood might not see risk, whereas someone in a bad mood would. People often become more optimistic and self-confident when markets rise, only to descend into fear and panic when they fall.
Avoiding the risk of over-reacting is key to long-term investment success. The best thing an investor can do is to know themselves and be ready to manage their emotions when markets rise and fall. If you’re feeling at an emotional extreme, whether it be greed, fear, or, or anything in between, it’s probably a good idea to avoid acting on those feelings. Of course, taking personal financial advice can help you to contextualise what you’re going through. Meanwhile, automating a regular monthly payment into a plan can also help to remove emotion from the investing process.
3. Reacting to short-term noise (‘Attention’)
“Nothing in life is as important as you think it is, while you are thinking about it,” wrote the psychologist and economist Daniel Kahneman.
As investors, it can be all too tempting to try to react to events as they happen. That’s because our brains are hard-wired to confuse how striking an event is with how likely it is to happen.
For example, shark attacks capture the public imagination, thanks to movies like Jaws. And yet they’re extremely uncommon. More real and insidious risks, meanwhile, like heart disease or diabetes, are harder to imagine – and so we down-weight them.
As investors, the answer is to try and avoid reacting to short-term events. The best investors do not seek to time the market by forecasting (or reacting to) short-term events. Rather, they know that uncertainty is what they are being paid for, and so they adopt principles for the long term. Such an approach may lack the excitement of responding to every news headline and market turn, but it will enable you to keep your eyes focused on the horizon. Regularly meeting with a financial adviser can help you stick to those goals.
4. Playing it too safe (‘Conservatism’)
We are all hard-wired for safety. It enabled our distant ancestors to survive in times when resources were scarce. Today, this conservatism could lead you to avoid less familiar investment options and taking less investment risk than you should. Over a lifetime, this could cost you thousands of pounds.
‘Conservatism’ describes our asymmetrical fear of loss, versus our happiness about reward. Literature suggests that people are two-and-a-half times more upset by a loss than they are happy about a comparably-sized gain. So, if you’re a gambler, winning £100 is no big deal. But if you lose £100, you’re pretty upset. We see this in the stock market too. Advisers get many more angry calls when portfolios are down 20% than they do thank you letters when portfolios are up.
Staying put in an investment irrespective of how it performs can end up doing you just as much damage as not investing at all. If you continue to hold, ensure you are doing so for good reason, keeping an open mind on alternatives, and periodically review your portfolio with your financial adviser.
If you’d like to know more about how to make better investment decisions, then speaking to a financial adviser is a good place to start. They will help ensure that you make the right decisions to ensure your long-term financial wellbeing. Contact us if you’d like to discuss your requirements in more detail.
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.