Emotions play a huge role in the stocks we choose, when we buy, and when we sell. And for the most part, they end up costing us money.
As the old investment adage goes, a portfolio is like a bar of soap – the more you handle it, the smaller it gets. But despite this, the average private investor trades around 75 per cent of their portfolio every year. So why does psychology rule so many investment decisions and how can you avoid the pitfalls of emotional investing?
Ben Hobson, markets editor at Stockopedia, a leading stock market analytics platform, gives his top tips on how to steer clear of investment behavioural traps.
Don’t be overconfident
It can be easy to become overconfident if your portfolio is performing well or if you think you’ve read everything there is to know about a stock. But this can give you a false sense of security which could cost you dearly.
Don’t be fooled. A lucky winning streak will always end, and if you rely on this and this alone, you won’t be a successful investor. The same goes for obsessively tracking and researching a stock. The more information you have, the more confident you’ll be, but studies have shown it doesn’t reduce risk.
Be aware of attention blindness
It’s logical to think that you see everything in front of you. But the reality is, under pressure or distress, your brain can easily miss things in plain sight. This trickery affects everyone and as an investor, it can lead to expensive mistakes.
Every investor must balance their primitive and impulsive emotive response (the so-called Monkey Mind) with modern human reasoning and the conscious calculation of risks and rewards. There may be times you need to make investment decisions quickly, but always stop and interrogate what’s in front of you before acting to avoid a costly misjudgement.
Override your instinct to react
As a private investor there’s nothing more tempting than checking the price of shares you own – weekly, daily or even hourly. Don’t!
This obsessive behaviour increases your chance of losing money. It exposes you to a raft of emotional triggers that, in turn, are likely to lead to overreaction and decisions made on the basis of instinct or fear. Each trade also incurs a fee, which adds up and eats away returns.
Stop following price movements and keep away from the news. Practically and philosophically, every investor should build and refine an investment strategy and then apply it consistently. This will prevent emotional trading and anchor your thought processes.
Don’t be led by FOMO
The most discussed stocks in the financial press are more often than not ‘expensive junk’. The problem is, private investors are easily swayed by the cool stock on the block and the fear of missing out (FOMO). The media should be used as a tool, not a financial adviser.
To find stocks that are statistically more likely to outperform, opt for factor-based investing. Factor investing is not new; it’s a well-researched approach that focuses on having strong exposure to the most important traits in shares, like value, quality and momentum.
Factor investing helps to reduce the impact of behavioural biases that can hurt the performance of your portfolio. It can also diversify your portfolio by introducing new opportunities in sectors you hadn’t considered before.
Diversify your portfolio
Having all your eggs in one basket can be a risky strategy but it’s a favourite among private investors.
If your portfolio is made up of investments that are too similar in terms of size and sector, you could be at risk of heightened volatility, which makes it very difficult to not be led by emotional triggers.
Instead, a diverse portfolio helps spread the risk and protects you from the pressures of market volatility. It balances investments that aren’t performing so well with those seeing positive results, giving you greater confidence in your portfolio and reducing the chances of you succumbing to emotional investing.
Disclaimer: Investing money carries risk, do so at your own risk and we advise people to never invest more money than they can afford to lose and to seek professional advice before doing so.
