How Emotions Impact Investment Decisions

We like to think of ourselves as rational creatures. We imagine that most of our actions are motivated by sensible logic.

But the truth is that we humans routinely make major decisions largely based on emotion.

The more uncertainty in the world around us, the more we rely on emotion over logic or the facts at hand. The study of how emotion affects our financial decisions is called economic psychology.

The general assumption is that when we make decisions on financial matters, our actions follow what is best for our own narrow self-interest, rationally deciding what to do.

But this is never actually the case. Investors tend to follow their emotions even when it’s not in their best interest. And the un-indicted co-conspirators in the financial media are consistently ready with anecdotal facts, data and statistics to support virtually any emotional conclusion one might reach.

Two of the emotions found most detrimental in financial decisions are overconfidence and regret.

Overconfidence

None of us likes uncertainty. So to compensate for the suspicion that we have very little control over what happens to us, we tend to cultivate overconfidence. This causes us to believe that we understand how the world works and therefore can reasonably predict what will happen next. To bolster this view, we routinely assign causes to an event after the fact, believing that we saw it coming all along.

This overconfidence in our own predictive gifts in turn causes us to expect the same in so-called investing experts: We want infallible market gurus who can tell us what will happen tomorrow, next week and next quarter. And, regardless of the fact that this is statistically impossible, there’s no shortage of financial pundits willing to present themselves as capable of filling this role.

Regret

Regret is one of the most painful emotions we can experience. It’s a combination of sadness and knowing we’re helpless to change what’s been done.

In the financial world, it’s what causes investors to purchase a stock or fund after it’s had a dramatic rise and then hold onto it as it continues to fall.  Or, perhaps worse, abandon a sound asset allocation strategy in the face of short-term downward market volatility.

Remember the primary decision that can turn a temporary decline into a permanent loss is to sell.

Overconfidence in how a specific fund or sector will perform followed by regret when it doesn’t can lead to what research has shown to be the most detrimental behavior for any investor: Repeatedly changing your mind.

Take Your Emotions Into Account

When you talk with us about your investment strategy and long-term retirement plans, it’s best to discuss the emotions that will come with participating in the market. You should acknowledge that you’re sometimes going to feel like radically changing your long-term plan is the only “logical” thing to do. Everybody experiences this.

Remember market research has shown that it’s the investor who does not react to his or her emotions who has the best chance for success.

To schedule an appointment to discuss your investment strategy or long-term plans, give our office a call at 215-968-1755.