Emotional Investing Part 1: Why Investors Behave Irrationally
This article is Part 1 of a two-part blog series on emotional investing.
Enduring the fluctuations of the market can be challenging, even for the most seasoned investors. Indeed, most of us know by now that staying the course is prudent—especially during periods of discomfort. Yet doing so may be easier said than done.
A successful investment strategy doesn’t just involve an understanding of how markets work. It also requires an awareness of our emotional biases and the discipline to keep them in check.
Unfortunately, too many investors fall prey to emotional investing and ultimately fall short of their financial goals.
Why Investors Get in Their Own Way
Researcher Herbert Simon concluded that most people use heuristics—i.e., mental shortcuts—when making complex decisions. For example, hiring managers often rely on a candidate’s past work experience and academic degrees to determine if they’re qualified for a particular role. Meanwhile, the truth is a multitude of factors can influence whether someone is a good fit for a position.
Similarly, investors are prone to using mental shortcuts when making investment decisions. A common example is herd mentality, which explains why investors often buy into euphoria and sell into panic. Another is confirmation bias, which causes investors to seek information that reinforces their existing beliefs and ignore facts that challenge them.
In short, humans are hardwired for emotional investing. Keeping your inherent biases in check can help you avoid making irrational decisions with your money.
Emotional Investing in Practice: The Greed and Fear Cycle
Emotional investing can manifest itself in a variety of ways. However, two primary emotions tend to motivate investor behavior over the course of a market cycle: greed and fear.
Greed: Why Investors Chase Returns
According to researchers from Stanford and Duke University, investors most fear the risk of underperforming their peers. Furthermore, the average investor will continue to invest with the crowd—even when they know it’s irrational—due to their fear of missing subsequent gains. This type of emotional investing can be problematic in practice.
First, the financial media tends to highlight popular indexes like the Dow Jones Industrial Average, NASDAQ, or S&P 500 to represent “the market.” Indeed, these indexes may be reasonable proxies for the U.S. stock market in many cases.
However, most long-term investors own a diverse portfolio of investments across multiple asset classes. In years like 2021, these investors may wonder why their portfolios aren’t keeping up with “the market.” They may even take on more risk than is wise, leaving themselves open to unnecessary losses when the market eventually corrects.
Greed and the fear of missing out also help explain why bubbles occur. Former Fed chair Alan Greenspan coined the term “irrational exuberance” to describe why investors drive asset prices higher than their fundamentals justify. We saw this happen with tech stocks in the late 1990s, real estate in the mid-2000s, and “meme stocks” in early 2021.
Unfortunately, bubbles eventually burst, and unlucky investors must accept their losses. In any event, emotional investing can cause investors to take on more risk than their circumstances and objectives warrant.
Fear: Why Investors Hate to Lose
The flip side of the emotional investing coin is the fear of loss. According to behavioral scientists Amos Tversky and Daniel Kahneman, the psychological impact of a financial loss is twice as powerful as a gain of the same magnitude. In behavioral finance, this concept is known as loss aversion.
Fear of loss can also be troublesome for long-term investors. An obvious example is wanting to go to cash and abandon an otherwise sound investment plan when markets are in turmoil.
On the other hand, fear of loss may lead some investors to take on too little risk, simply to avoid the pain of seeing temporary losses in their accounts. As a result, these investors may not own the right mix of investments to reach their long-term goals.
Emotional Investing Comes at a Cost
Making investment decisions based on fear or greed may be satisfying in the short term. Unfortunately, emotional investing tends to be counterproductive when it comes to achieving your long-term financial goals. In Part 2 of this two-part blog series, we examine the potential costs of emotional investing.
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