How Emotions Affect An Investor In The Stock Market
Investing in the financial markets can oftentimes be similar to riding a rollercoaster. With volatility and unpredictable moves that can make or break your investments, controlling your emotions can be quite challenging. Most investors tend to ignore psychology and emotions and focus more on investment strategies. However, to succeed as an investor, controlling and managing your emotions is crucial as it can help you make better investment decisions and grow your capital consistently.
A person who has control over their emotions and understands the importance of psychology while investing can create huge wealth from the markets. On the other hand, emotional investing can lead to huge losses and destruction of wealth. Managing emotions like greed, fear, overconfidence, nervousness, and not letting them affect your investment decisions is something that one learns with experience.
However, we at Financial Education believe that with the right guidance and knowledge, investors can control and keep their emotions at bay while dealing in the stock market. In this article, we will understand how emotions can affect your performance as an investor and how you can control them to make the best possible investment decisions. So, let’s get started!
Common Emotions That Affect an Investor
Human Beings are filled with emotions, and these emotions affect our lives in several ways. When it comes to investing in the financial markets, emotions, psychology and mindset play a huge role. Investing without a system or not doing the necessary due diligence and research can lead to huge losses. To succeed in the financial markets, one needs to maintain a balanced state of mind and not let external factors affect their decisions.
The stock market often plays with our emotions and causes us to take irrational decisions, that eventually lead to bad investments. The only way to avoid this is by not letting fear, greed, and other emotions take control of our minds.
When it comes to money, people tend to get emotional and their judgment can oftentimes get clouded when the market moves against them. This causes people to panic and make irrational decisions that they later regret. For example, an investor who’s been holding on to a stock for quite some time may hear news on the radio that the company he’s invested in is about to declare their quarterly earnings report and it is expected to be negative.
Now, filled with fear and panic, the investor decides to sell his investment immediately in order to avoid a huge loss. However, the next day results come out and they’re much better than anticipated, which leads to a huge increase in the stock price. Now, the investor will be left frustrated and saddened by the decision he made, all because he let fear and nervousness take control of his mind. If only he would have thought logically and analyzed the situation with a calm and unbiased mind, this situation could have been avoided. This is how emotions can play with your mind and cause you to make bad investment decisions.
Emotions That Affect an Investor
Financial ratios are practical tools that assist companies and investors examine and make comparisons between their financial relationships and the accounts on the company’s financial statements. It is a tool that makes financial examinations possible across a company’s history, an industry, or a business sector.
Company owners and their management usually use the data analysis collected from the calculation of these ratios to make proper decisions about improving the company’s profitability, liquidity, and solvency.
Greed is one of the most common emotions that have a huge impact on an investor. People act greedily when the expected reward far exceeds the expected time and cost to be invested. This leads to excessive purchasing and irrational investment decisions without even analyzing the situation. People tend to ignore all other factors and only focus on the amount of money they can make.
To be a little greedy while investing is a motivational factor for success. But the desire to get-rich-quick causes investors to take extremely high risks, which can oftentimes lead to huge losses. Allowing emotions like greed to take charge of your investments is something that you should avoid at all costs.
Overconfidence is another reason why several investors end up losing all their gains in a very short amount of time. The feeling one gets after being correct about a stock and its movement can oftentimes make a person overconfident about their skills and judgment. While being confident in your research and analysis is a good thing, being overconfident is something that you should avoid.
Always research and analyze every investment opportunity with an unbiased mindset and avoid making random investments that you feel will work out, as most of the time, they won’t.
Fear & Nervousness
Fear and nervousness can wreak havoc in an investor’s mind. Both these emotions can cause people to take irrational decisions without even considering the results their actions will have. When a person has been in a losing phase for a long time or his portfolio is giving negative returns, they tend to become fearful of further losses. Investors end up booking profits too early and keep holding on to their losses in hope of reversals.
The fear of losing profits back to the market makes an investor book their profits early, and they later realize that the returns could have been much higher if they would have held on a little longer. Fear and nervousness are an investor’s biggest enemies.
Indecision is another emotion that causes investors to make irrational investment decisions. Confusion and uncertainty are a part of the stock market, as trends and market sentiment can change anytime due to external factors. This puts an investor in a state of indecision as rapid changes and high volatility in stock prices can confuse an investor. Indecision also causes investors to randomly enter or exit an investment, which leads to nothing but losses.
FOMO: Fear of Missing Out
Fear of missing out or also known as FOMO is one of the biggest factors that cause investors to make irrational investment decisions; just so that they aren’t left behind. Increasing public interest for a particular stock or a piece of news that might affect its price can cause people to jump into that stock without considering the outcome.
While sometimes the investment may bring positive returns, investing due to the fear of missing out is something that you as an investor should avoid. Making your own investment decisions and avoiding news is the best way to control FOMO.
While it is not bad to plan your investments and hope for certain targets, the issue arises when you stick unrealistic expectations with the investments you make in the stock market. You may have seen several legendary investors like Warren Buffet make billions through investing in the stock market and holding on to their investments, but they do so in a well-organized, planned, and researched manner, unlike retail investors who hold on to investments with unrealistic hopes and expectations.
How to Make Better Investment Decisions?
A study presented in 2001 by Dalbar and renewed in 2015 indicates that an ordinary investor attained a 5.32% return over 17 years while the S&P 500 averaged 16.29% periodically. You may be wondering about the reason behind the average investor attaining such a low return. Well, the reason lies in the average investors’ psychology and control over emotions.
So, how can you control your emotions? Well, emotions are a part of our lives, and keeping them in control while investing can be a challenging task. However, with systems and techniques like systematic rule-based investing, diversification, dollar-cost averaging, and more, you can keep your emotions under control and reduce their impact on your financial decisions. Here’s how you can minimize the impact of emotions on your investment decisions –
Systematic Rule-Based Investing
Systematic investing is a process in which you invest only when a particular set of rules are fulfilled and certain market conditions prevail. This ensures that you do not make random investments and end up losing your capital. Rule-based systematic investing helps an investor defines the exact criteria like where they can enter a stock and when they should exit their investment.
Everything is pre-defined in the system and randomness is completely removed. This ensures human emotions have a very minimal impact, increasing the profitability and winning chances of an investor.
Rule-based investing can help keep emotions in control and have a very minimal impact on your decisions. This will ensure that you have a peaceful and relaxed mindset when investing in the stock market. Since all the details are already provided by the system, all you have to do is execute and follow the rules. This creates a stress-free environment and allows the investor to make well-researched and low-risk investments.
Dollar-Cost Averaging (DCA)
Dollar-cost averaging is an investment strategy in which the investor invests a fixed amount of money at regular intervals in any particular asset to minimize the impact of market volatility on the overall investment. The purchases occur regardless of the asset’s price and at regular intervals. In effect, this strategy removes much of the detailed work of attempting to time the market in order to make purchases of equities at the best prices.
Dollar-cost averaging is also known as the constant dollar plan. The goal of dollar-cost averaging is to reduce the overall impact of volatility on the price of the target asset; as the price will likely vary each time one of the periodic investments is made, the investment is not as highly subject to volatility.
Diversification & Asset Allocation
Diversification and asset allocation are a great way to minimize the effect of emotions on your investments as this allows you to create a balanced portfolio. The benefit of having a well-diversified portfolio is that no single market event or high volatility in any of your investments can cause a huge impact to your overall portfolio.
This is because it also allows your portfolio to remain balanced even if one asset class underperforms, as the other asset classes in the portfolio will balance the drawdown, helping in getting stable and consistent returns.
Asset allocation is a way of investing your capital into different asset classes according to your goal, risk profile, and investment horizon. The objective of allocating your capital into different asset classes is to minimize the overall risk of your portfolio and take advantage of cross-sector investing. This ensures that your portfolio grows at a steady and consistent pace while minimizing the overall risk.
Historically, the returns of all the major asset classes have never moved up and down in a similar fashion, rather they move with their own trends. This gives an investor the opportunity to diversify their capital into several different types of asset classes and ensure that the overall risk of the portfolio is reduced significantly.
Now, with all this information, we hope that you understand how emotions can have a huge impact on your investing career and be the factor behind your success or downfall. While it is not possible to eliminate emotions completely, we can minimize their impact on our decisions by using several methods as discussed above. By using methods like systematic rule-based investment approach, diversification and asset allocation, and dollar-cost averaging, you can keep your emotions at bay and make unbiased and logical investment decisions.
We hope that this article provided you with interesting and valuable information, which in turn will help you make better investment decisions. If you would like to see more such interesting content on the financial markets, then do check out Jeremy Lefebvre’s YouTube Channel “Financial Education”. Happy Investing!