Developing the right mindset can help to improve your investing. Whether you’re planning your investments or watching the value of your assets fluctuate, emotions can influence your decision-making. This is something that needs to be considered throughout the entire life cycle of a trade.
Studies into the psychology of investing highlight that, alongside an element of common sense, there are more obscure biases that need to be understood. Regardless of the amount of money at stake, it’s important to be aware of how psychology and emotional investing can impact your returns, as well as any responses to market changes. Discover what emotional investing is and how to avoid it.
Being realistic about your aims, developing a clear strategy and gaining a better understanding of the key investment terms is a great foundation for any investment plan. However, aspects of human behaviour can unintentionally influence your approach and potentially lead to poor decision-making. Emotional investing is usually bad investing, and there are several psychological pitfalls of which investors should be wary.
Understanding the Psychology of Investing
Tip: Beware of cognitive bias. The human brain is designed to simplify information and decision-making using filters based on personal experience and preferences. Emotions can lead to you cutting corners and being over- or under-confident.
Planning Stage
When developing your investment strategy, extra caution is required to avoid falling into some of the pitfalls experienced by new investors.
| Pitfall | Definition |
|---|---|
| Familiarity Bias | Investors focus on assets and markets they’re familiar with, rather than exploring new areas that might be a better fit for their risk-profile. |
| Anchoring Bias | Investors rely heavily on the first piece of information they receive, which leads to them overlooking other, relevant factors. |
| Restraint Bias | Investors overestimate their ability to show restraint in the face of temptation, which could lead to greater exposure. |
| Herd Mentality | Investors let their investment decisions be influenced by the actions of others, rather than through their own research. |
Tip: Restraint bias can also be problematic when managing live trading positions. “Doubling down” on a losing position is not usually considered to be the best option and is perhaps one of the best examples of emotional trading.
Investing Stage
Once you’ve entered into a position, the way it fluctuates in value according to live market prices can trigger a range of other factors and biases, not necessarily witnessed in the planning stage.
At this stage, investors will possibly start to experience losses, which makes them question their strategy, and whether there has been a shift in market conditions that makes it ineffective.
| Pitfall | Definition |
|---|---|
| Confirmation Bias | When investors seek out information that supports an investment decision, rather than new, alternative views that might challenge it. This can leave investors blindsided when things go wrong, because they’ve convinced themselves that their decisions are financially viable. |
| Loss Aversion Bias | When investors have a risk profile that prioritises avoiding losses over making gains. A lower risk-return ratio is unlikely to provide the long-term rewards that investors are looking for. |
| Win-Loss Ratio | When investors want every trade to be successful, and so stick with bad decisions rather than cutting losses. |
Each of the psychological factors that can result in emotional investing can be addressed individually and by developing a well-thought-out, overall plan.
In addition, investors should consider another crucial bias: the tendency to procrastinate. Regardless of which emotions can come into play, the reasons for investing remain valid. Whether you’re looking to protect your wealth from inflation or planning for financial independence and early retirement, procrastination is a problem that many new investors face. Sometimes, the biggest risk is not taking any risks at all.
How to Avoid Emotional Investing
More important than anything else, new investors need to acknowledge that, no matter how foolproof their strategy is, there will be losses at some point along their investment journey.
Experienced investors tend to focus on their long-term goals, rather than short-term pain from any temporary losses, which can help to avoid emotional investing. Don’t focus on your win-loss ratio, but instead, aim to make an overall positive return. Consider the phrase: “run your winners and cut your losses.”
Each of the psychological factors that can lead to emotional investing can be addressed individually, with a well-thought-out, overall plan.
- Conduct as much research as possible and keep up to date with market news.
- Be realistic about your aims and personal risk profile.
- Diversify your portfolio to reduce volatility.
- Review your actions and investment plan to make sure you’re avoiding beginner investment mistakes.
- Consider updating your strategy, or better still, factor in adaptations at the planning stage, depending on how certain scenarios might play out.
The most important quality for an investor is temperament, not intellect.
Warren Buffett
Final Thoughts
Regardless of whether your investment portfolio is rising or falling in value, there are methods you can use to develop an investing mindset and optimise your returns. Develop an understanding of the ways in which greed and fear can cloud decision-making and instead concentrate on influencing the elements of the investment process that you do have control over.
Visit the eToro Academy to learn more techniques designed to help you to develop a successful approach to trading.
Quiz
FAQs
- Is there a way to measure the mood of the market?
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The CBOE Volatility VIX Index measures trading activity in the options market. These instruments are often used to manage risk; the greater the amount traded, the higher the number of investors who believe that the US stock markets could experience a dramatic price move in the near future. Based on data from the Chicago Board Options Exchange, it is used to monitor investor sentiment. Sometimes called “the greed and fear index,” the higher the reading of the VIX, the greater the concern from investors that price volatility will increase in the future.
- What techniques can I use to take the emotion out of investing?
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The dangers of emotional trading have prompted a range of strategies to be developed to counteract it. Portfolio diversification, which involves buying a variety of assets, can average out returns and reduce the emotional reaction to increased market volatility. It’s also worth considering dollar-cost averaging, in which investors place equal amounts of capital into their investment plan at regular, predetermined levels, thus, removing an element of emotion.
- How much should I invest to avoid emotional investing?
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Traditional investment advice suggests that investors should avoid committing more capital than they can afford to lose completely. For beginner investors, starting off small and gradually building up your portfolio, will help you to acclimatise to the inevitable ups and downs of the market.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.