Don’t let emotions sabotage your investment goals

MONEY is part of our everyday life. It is earned with effort and time, which explains why we attach emotional significance to it. These feelings are magnified when it comes to investing.

Investing involves the allocation of your hard-earned money into stocks for the promise of future rewards. The uncertainty of the investment outcome is accompanied by a burst of emotions as you see the value of your money rise and fall.

Hence, it is not surprising that psychology plays a major role in determining how you invest. If you are not careful, these emotions end up sabotaging you, leaving you with poor investment results. Successful investing is more about keeping calm than about possessing superior intellect.

We are all human, though. It is impossible to eliminate the emotional aspect of investing. But by being aware of your psychological tendencies and emotional pitfalls, you can slowly learn to become a better investor.

Here are a few emotional biases and fallacies that could trip you up as you invest.

Glossing over the risks

It is not unusual to hear talking heads on television proclaim that they know where the stock market is headed. These self-proclaimed experts can also confidently tell you which stocks are attractive and which sectors are poised to do well.

A confident tone is a surefire way to catch the audience’s attention as investors search for reasons for share price movements. Unfortunately, some investors may end up being overconfident because they have read extensively on a stock.

This overconfidence can be dangerous as it blinds you to the risks of an investment. Being overconfident also results in excessive trading as the investor feels certain that he can capture every profitable stock movement.

The way to guard against overconfidence is to remind yourself of the unknowns and hidden risks of every investment. Better still, get a reliable friend to offer counter-arguments to bring you back down to earth.

Desire for certainty

Humans struggle with uncertainty and their brains regularly search for patterns for certain phenomena. When dealing with a major event such as an economic crisis, there is a tendency to tell yourself that you had accurately predicted the outcome before it happened. This psychological tendency is known as hindsight bias.

This behaviour can lead investors to erroneously conclude that they can accurately predict events beforehand and stake their money on such predictions.

Yet another common psychological behaviour is confirmation bias. This is the tendency to seek out information that conforms to your beliefs, even if the information is flawed or one-sided.

An investor who has a favourable opinion of a stock ends up searching for positive information on that stock while the brain rejects any negative information. Such a bias means you may end up with a lemon if you fail to recognise the negatives associated with the stock.

Luckily, it is relatively easy to mitigate the effects of these two biases. Keeping an investment journal can help you avoid hindsight bias as you document your decision-making process. In the future, it is easy to check back to review your thoughts and determine that you could not have accurately predicted the outcome of each event.

Drawing up a list of pros and cons is an effective way to counteract confirmation bias as it forces you to recognise both the merits and risks of an investment.

Actively seek out information that differs from your views to obtain alternative opinions. Doing so helps to keep confirmation bias at bay as you process both the good and the bad when you decide whether to purchase a stock.

Hanging on to losers

The logical thing to do with your portfolio is to optimise it by getting rid of the losers and retaining the winners. I had written about this in my previous column about tending to your portfolio like a garden by pulling out the weeds and watering the flowers.

Many investors find this task daunting as their minds are anchored to the price at which they purchased the shares. Logically, if the stock is a lemon, the best course of action would be to sell it and redeploy the money to a more promising candidate.

Anchoring causes an investor to hold on to a losing position in the hope that it would eventually break even. The problem is that the stock does not know or care who bought it, and the share price in the short term is dictated by sentiment.

Loss aversion

Loss aversion is another emotional bugbear, causing investors to hang on to losing stocks to avoid “locking in” the loss. On the flip side, loss aversion prompts investors to sell their winners too soon as they worry that these profits will turn into losses.

This combination of anchoring and loss aversion has an insidious effect on investors’ portfolios. Poorly-performing stocks will continue to be a drag on portfolio performance while the opportunity cost of redeploying the money means you will be missing out on attractive opportunities.

To avoid being trapped by these biases, you should start on a clean slate when evaluating any stock. Disregard your purchase price and any unrealised losses relating to the stock, and make a cold and rational assessment of the business and its prospects.

Struggling businesses should be sold in favour of promising ones. This method of “cleansing” your portfolio will enable you to enjoy significant capital gains on your winners while keeping your losses manageable.

Manage your emotions

When investing, it is useful to formulate an investment plan and adhere to a rigorous process. If you fall prey to the emotional traps described above, you may end up stumbling and losing a significant chunk of money, thereby delaying, or disrupting your financial goals.

Retirement need not be a pipe dream. Learning more about how your emotions can sabotage you helps you to become a better investor.

Inevitably, you will still make mistakes. But with a firm understanding of these emotional pitfalls, you can learn from your mistakes and eventually become a successful investor.

The writer is portfolio manager of The Smart Investor, a website that aims to help people invest smartly by providing investor education, stock commentary and market coverage.