One of the most important factors when making investments is the ability to manage your own emotions which can be hard more often than not. Being human means that emotions will be an essential part of that.
The interesting part is that most economic models assume that human beings make logical and rational decisions by reasoning out the most sensible choice.
However, anyone who has been in situations where you can make logical and rational decisions like asking someone out or buying something has ended up being driven by emotions. We can say that emotion-free decision making is non-existent. And this is why behavioural finance exists, it attempts to understand how human behaviour affects markets.
When Panic, Fear and greed start driving investing decisions can make things go from bad to worse. A good example is the Coronavirus pandemic that has led investors to sell their stocks because of the panic which has led to losses for some investors because most of us are wired to avoid loss (loss aversion).
In other words, loss aversion is, losing something feels worse than gaining the same thing. This can cause us to do what we think we need to in order to minimize that loss immediately. An example would be let’s say there is an investment opportunity that has a 50-50 probability of gaining or losing the same amount with loss aversion we would avoid the investment because of the 50% probability of losing it.
There is also where we experience FOMO (Fear of Missing Out) when we see an investment that we don’t own start to increase in value quickly. When we make investments we are worried whether we will be greatly rewarded, lose everything or be in between and no matter how much research we do or how many opinions we get from others we cannot with certainty know how our choices will play out.
These emotions may cause us to buy an investment when it’s at its peak or sell too early or late. This leads to one being an irrational investor and it is this kind of irrational, emotional behaviour that leads to bankruptcies, booms and busts.
How can I avoid making investment decisions based on emotions?
I have been a culprit of emotionally investing in the past and this has led to monetary loss but on the bright side, it has made me better at avoiding emotionally driven decision making.
The following techniques have helped:
- Setting investment goals- The question should be what do I want to achieve financially? It is important to have investment goals broken down to short, medium and long term and determine them early because it helps in defining your investment horizon, risk tolerance and overall investment plan. Knowing what you want to achieve with a specific investment allows you to evaluate it while still in it. This helps you to steer away from the appeal of emotional investing.
- Do away with the group mentality– A lot of us have had the fear of missing out (FOMO) at one point in our life. Do not get into an investment just because everyone else is doing it instead, do your research before getting into any investment.
- Using media as a tool and not a financial advisor– Of late we have seen investments go sour that was advertised on TV and investors put all their hard-earned money for them to lose all of it. News is a good way to stay informed but should not determine your investment strategy. Use the news as a data point to get market trends and investment opportunities.
- Do not put all your eggs in the same basket with a different name- This can never be overemphasized. Diversify Your Portfolio across different classes or across industries. A diversified portfolio will not have higher returns but will help in balancing out negative and positive returns. It provides a shield in a market downturn in that you do not feel the sting of losses as harshly and increases your own confidence in your portfolio reducing the chance of selling when times get tough therefore reducing the odds of emotional investing.
Sitting tight in a volatile market, entering the market or diversifying your portfolio can be tough and it is not uncommon to get trapped in behavioural investing. That is why Vasili Africa exists to help you.
This article was written by Caroline Musau, Chief Operating Officer at Vasili Africa. Get in touch with Caroline for free investment advice via info(at)vasiliafrica.com