We all have emotional tics, or emotional reactions that we can't always control. One commonly documented example is the undue weight we give to recent events. Say an economy is going through a bad patch and it’s affecting an investment, we will often only look at recent figures – just like if we fell down the stairs, we’d be more careful over the next few weeks. However, that ignores the important stuff that should influence their behaviour: the economy’s longer-term economic strength, or the hundreds of times you successfully descended the stairs. For investors, this attitude can be detrimental, leading them to overestimate the importance of recent news events, perhaps selling out at the first sign of volatility.
There are a number of ways to take the emotion out of investing and become a better investor:
Step one: Would you do something differently had the opposite happened?
Markets tend to undervalue stocks that have recently fallen, while becoming very optimistic about stocks that have recently gained in value. Therefore share prices will often overshoot on the upside and the downside.
When considering an investment, ask yourself: would you do anything differently if the opposite had occurred? What if things had shot up instead of down? If the answer is yes, you’re making decisions based on short-term bias. Stop. Take a breath and try to look at the big picture. This makes good financial sense: The ‘founders’ of behavioural economics, Werner De Bondt and Richard Thaler, found that those stocks previously considered ‘losers’ outperformed those previously considered ‘winners’ after 36 months.
Step two: Don’t follow the crowd in and out of the market
Just before a financial crash, people are generally pouring more money into investments. The they tend to be taking it out before a big rise in prices. This is the opposite to what should be happening if investors want to buy low and sell high.
When markets are rising and falling quickly, it’s common that emotion takes over, sometimes impeding rational thinking. When prices are rising an investor might feel over-optimistic, believing they are going to make lots of money. They collect evidence that supports their optimism, ignoring anything that suggests they should be more cautious. The opposite is true as markets fall.
Step three: Think about when you make your investment
If there has just been an upturn in the market, you might wish you had invested earlier. If it has just fallen you might feel that further investment could be too risky. Realistically there is never a ‘good’ time to invest. But you should not make investment choices based on hope or regret.
The smart investor knows that an investment is for the medium to long term. Looking at past trends, an investment in the stock market tends to be more likely to beat inflation than cash. Investments protect the real value of your wealth. Saving regularly means you will buy and sell at different points in the market and this can help even out your return over time.
You may also want to consider outsourcing your investment a third party, such as a discretionary manager, or to a multi-manager fund. This means you are not making the day-to-day decisions and removes the temptation to tinker with your portfolio. Emotion should take second place to fact when it comes to investment.
This article appeared in its original form on the Moneyfarm blog