How Do Your Emotions Actually Impact Your Investments?

This phenomenon is known as emotional bias, and it can be a significant hurdle if you are looking to build long-term wealth.

‍

What Is Emotional Bias in Investing?

Emotional bias occurs when your decisions are influenced by your emotions, often leading to irrational behaviour. Whether through fear, greed, or even attachment to a particular stock or asset, emotions tend to cloud our judgement.

‍

The result is that our decisions may go against sound financial principles or long-term investment strategies.

‍

You may fall prey to these biases by holding onto a stock for too long, buying into a popular trend at its peak, or avoiding necessary risks. Emotional bias can derail your from your investment plan, which can ultimately damage your portfolio’s growth potential.

‍

Common Emotional Biases

Some common examples of emotional bias that can affect you include:

1. Loss Aversion: You can often fear loss more than you might value gains. This leads to reluctance in selling losing investments, hoping they will recover, even when the rational decision might be to cut losses.
2. Overconfidence: You may believe you can ‘beat the market’ and trust your intuition over data. This overconfidence often results in excessive risk-taking.
3. Herd Mentality: Following what others are doing, whether it is chasing a popular stock or pulling out of the market in panic, can lead to poor decision-making.
4. Endowment Effect: This bias makes you overvalue your own assets simply because you own them. The emotional attachment often prevents selling at a logical point, despite declining performance.

‍

The Danger of Not Selling an Asset in Time

One of the more dangerous aspects of emotional bias in investing is when you hold onto assets longer than you should, particularly if you have a set target value.

‍

Consider a scenario where you buy a stock, thinking you will sell once it hits a 20% gain.

‍

The stock reaches that target, but instead of selling, you hold on because you believe the price will continue to rise.

‍

It is quite easy for emotional biases to take effect in this example, especially greed and overconfidence, and you may fail to sell the stock even when it aligns with your original set target value.

‍

Should the stock eventually decline, so too would you lose the gains you had aimed to achieve in your original strategy, a too-common example of how emotions can sabotage investment decisions.

‍

Fear and Greed: The Two Dominant Forces

Fear and greed are often the primary drivers of emotional bias.

‍

When markets are volatile, fear can lead to panic-selling or avoiding investments altogether, missing out on potential gains.

‍

On the other hand, greed can lead to chasing trends or holding onto investments longer than is sensible, as seen in the above example of not adhering to a predetermined investment strategy in favour of the possibility of greater gains.

‍

How to Manage Your Own Emotional Bias

There are some key ways to manage and reduce the impact of emotional biases when it comes to investing.

‍

These include:

1. Have a Plan: A well-constructed investment plan can serve as an anchor during times of market volatility or emotional stress. It helps you stick to your strategy and avoid rash decisions based on emotions.
2. Set Clear Goals: By having clear entry and exit points, you are less likely to be swayed by short-term market movements. Know your risk tolerance and your long-term objectives.
3. Avoid Checking Your Portfolio Too Often: Constantly checking your investments can heighten emotional responses to short-term price movements. Instead, schedule regular check-ins (quarterly or annually) to review your portfolio objectively.
4. Diversification: A diversified portfolio can reduce the emotional rollercoaster associated with holding individual stocks or assets. Spreading your investments across asset classes, sectors, and regions minimises the impact of any one investment’s performance.

‍

The Importance of Discipline

Successful investing is about discipline.

‍

When you allow your emotions to dictate your actions, you stray from a more rational investment strategy.

‍

Discipline means sticking to your plan, whether the markets are soaring or plummeting, and not letting short-term noise alter your long-term goals.

‍

Is Emotional Bias Hurting Your Investments?

Emotional bias can be a major hurdle in achieving financial success.

‍

While it is impossible to remove emotions from investing completely, investing should be driven by data, logic, and a solid financial plan — not emotions.

‍

Please note that all information within this article has been prepared for informational purposes only. This article does not constitute financial, legal or tax advice.