There’s not an investor on this planet who hasn’t felt the deep pit of despair when seeing their portfolio drop. That intense feeling of panic has caused countless people to sell out of stocks or do something else they wouldn’t otherwise normally do. At the same time, the elation of seeing an investment jump has made too many investors overpay for more of that same asset or hang on to a company for far longer than they should.
Whether we like it or not, our emotions impact how we invest in big and small ways – just like how they dictate so many other things in our lives. Do you know that investors will bid more on new share offerings from companies on sunnier days? Similarly, a country’s poor performance in the World Cup can lead to stock market losses of almost 50 basis points in that country. Indeed, everything from greed, fear, excitement and more often dictate our financial decisions.
“A good mood can increase optimism and risk taking. When you’re feeling good, you might think, ‘I’m going to buy a little bit more.’ On the other hand, people tend to be more pessimistic and risk-averse when they’re fearful,” says Ing-Haw Cheng, an associate professor of finance at the Rotman School of Management who researches how beliefs and incentives affect capital markets and the economy.
The only way to make better financial decisions is to understand how emotions can get the best of your wallet, and find ways to battle back against your gut feeling.
Don’t let a big win drive future investments
Research from Taiwan shows that a big pay-off on an investment can make people overconfident. They then invest too heavily in risky assets, thinking their luck will continue.
“People tend to rely a bit too much on their past experiences,” notes Cheng. “The past can predict the future in certain circumstances, but sometimes not as well as people think.”
Did your tech gamble pay off? Great, but that doesn’t mean you should put all your cash into Silicon Valley. It’s always important to maintain a diversified portfolio across sectors, asset class and geography. It’s less exciting, but a balanced portfolio reduces your risk.
Check in with a financial advisor
Ideally, says Cheng, “we should make financial decisions in an emotionless state. We should be forecasting how much money we’re going to make in the future, how much return our investments are going to make, and when we need to spend that money.”
Too often, however, we make decisions without weighing objective factors, including how an investment decision fits in with an overall portfolio. A financial advisor can provide that bird’s-eye assessment by seeing if your investments are diversified enough, and if your risk exposure aligns with your spending and retirement goals.
Advisors should be akin to doctors, says Cheng, offering periodic check-ups on your financial health. “An advisor can ensure that you’re sticking to the core rules of investing,” he says.
Set up regular contributions
Most of us get much more joy out of spending money today than we do saving money for tomorrow, which is why Cheng recommends setting up regular contributions to retirement savings plans. That way, our emotional brains don’t have a chance to earmark that money for vacations or new luxury goods. “It can be helpful to have some mechanisms for self-control,” he explains.
Look out for other people’s feelings, too
It’s also important to be mindful of professional advice you receive to ensure it isn’t being driven by emotion. “If your advisor is telling you to invest only in five stocks, or trade frequently, or buy mutual funds that have very high fees, those are generally red flags,” Cheng says.
Look for an advisor who sticks to the basics and understands your personal situation rather than one who offers an under-diversified strategy. By the same token, you want to be wary of a friend or family member who is overexuberant about an investment opportunity. It’s likely overconfidence is clouding their judgment.
Be mindful of your emotions
Ultimately, simply understanding your emotions will help you push them aside, says Cheng. A good example is in real estate transactions, where a panic-induced bidding war can lead you to exceed your home-buying budget. “Real estate is not just an investment, it’s also where you live,” he explains. “There’s a lot of emotion tied up in that, which can make it hard to make appropriate decisions.”
Regardless of whether it’s anxiety or excitement, emotions are often knee-jerk responses that don’t involve much logic. By taking a beat before reacting to the pressure to make that big investment decision, you can let cooler heads – and logic – prevail.
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