Learn about emotion and investment decisions

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We all understand the connection between emotion and investment decisions don’t we?

Investing is a very rational process, after all it’s all about numbers and money.

Right?

Wrong!

We have to learn how to take the emotion out of investment decisions!

For the vast majority of people it is the very opposite and most investment decisions are made based on emotions.  And when emotion and investment decisions are inextricably connected, those decisions may often be the wrong ones.

So what are the “tips and tricks” that the really successful investors use and how can you do the same?

Financial markets are difficult to understand but they have fluctuations based on economic cycles.  Sadly they certainly don’t just follow an upward line! Otherwise we would all be millionaires.  With hindsight, these fluctuations are what provide the maximum opportunity for the investor but without the benefit of hindsight, how can you maximise your investments?

The typical investor’s emotional curve.  This is the range of emotions you can go through as the financial markets rise and fall over time.  The following schematic illustrates this, although of course the timescale for this pattern can vary between months and sometimes years.

Investment + emotions

 

 

Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria.” –  Sir John Templeton

 

 

 

The effect of emotion is that you will be inclined to invest when the market is at a peak and sell when the market is at its lowest. The consequence of this (in addition to a lot of stress) would be to minimise your potential returns.

What we should be doing is actually counter intuitive – as Warren Buffet said “Be fearful when others are greedy and greedy when others are fearful. Sell when the financial markets are high and buy when they are low.

Although there are very complex mathematical approaches based on trends for investment decisions: about buying (when the market is low) and selling (when the market is high), this is certainly an unemotional approach. Although generally a successful one,  is not too common.

So how do the very successful investors, such as Warren Buffet and Sir John Templeton, navigate this emotional wave in a different way to achieve consistent positive returns?   They will use an unemotional process built from an understanding of personal risk and expectation of return and the appropriate asset allocation.  Using an impartial intermediary, such as a qualified financial planner, will add both professional understanding and advice and also an unemotional steadying hand when market movements are significant.

What does asset allocation  mean?

For the investor, monies can be placed into a range of assets such as cash, bonds, property, equities, commodities and sometimes complex financial instruments. Selecting how much of a portfolio should be invested into some or all of these categories is called asset allocation.  Over time some of these assets will grow more than others and a structured approach to investing can ensure that you “re-balance” your portfolio over time: effectively taking profits and selling where one asset class has grown more than others so that you retain the same broad asset mix.

So the idea behind asset allocation is to have a portfolio which performs as below:

Asset allocation

 

 

 

Some assets are termed “non-correlated” whereby their price movements are not connected to stock market sentiment and analysis but have a different  underlying value. An example is property funds.  Including these type of funds can smooth the overall performance of your portfolio.

To summarise, successful investors use defined processes to navigate the peaks and troughs of the investment market.   Of course we can’t always second guess how the markets will perform, but we can ensure that you have a widely diversified asset allocation to help mitigate the uncertainty. Having a calm, unemotional financial adviser to help you make these decisions can make a significant difference.

Author: Melanie Barker

Originally a guest post for 3Plus International  www.3plusinternational.com

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