Keeping your emotions at bay when making investment decisions can be extremely difficult. Research from the U.K. found that half of all investors had made an impulsive investment decision, with two-thirds of them later regretting that decision. Fear of losses, excitement and the fear of missing out were all listed as some of the reasons for making these impulsive decisions.
Behavioural economics examines how our biases and emotions can affect our investment decision-making process, which in turn can lead us to act irrationally. When it comes to preserving the value of your investments, understanding these behavioural tendencies can help you to make better investment choices and avoid costly mistakes.
Let’s explore four key behavioural economics traits and the impact they can have on the value of your investments.
Loss aversion: the fear of losing
Loss aversion is the tendency to feel the pain of losses more than the joy of gains. In investing, this can lead to overly cautious behaviour or overreactions to market downturns.
While a cautious approach can align with the goals of capital preservation, excessive loss aversion can lead to:
- Avoiding opportunities provided by slightly riskier assets, such as equities (shares), which typically provide inflation-beating returns over the long term.
- Keeping too much money on the sidelines, which erodes your purchasing power over time due to the impact of inflation.
How you can manage it:
- Focus on the long-term: remind yourself that markets have always recovered eventually, and short-term market fluctuations don’t necessarily lead to permanent losses.
- Diversify: a well-diversified portfolio can reduce the fear of losing all your capital.
- Work with an advisor: professional guidance can help balance risk and reward objectively.
Herd instinct: following the crowd
Herd instinct refers to people’s tendency to copy the actions of a larger group, without their own independent analysis.
In times of market volatility, herd instinct can drive investors to follow trends that may not align with their financial goals, for example:
- Panicking and selling assets during market downturns, to follow the herd, locking in losses unnecessarily.
- Buying “hot” assets, when they’ve already reached their current peak.
- Buying speculative investments that can expose you to unnecessary risk.
How you can manage it:
- Stay disciplined and stick to your investment strategy, even when others are making impulsive decisions.
- Base investment decisions on objective research and advice, not popular opinion.
- Focus on preserving your wealth over a long time frame, rather than reacting to short-term market trends.
The framing effect: how choices are presented
The framing effect happens when the way information is presented influences decision making. For example, people may react differently to a portfolio described as “70% safe” versus “30% risky”, even though both mean the same thing.
Framing can skew how investors perceive risk and returns, leading to faulty decisions, for example:
- Emphasizing the potential for loss may discourage investors from considering investments that have the potential to outpace inflation.
- Being overly reliant on and overconfident in “guaranteed” returns may lead to over-investment in lower growth products, depriving your portfolio of its necessary growth potential.
How you can manage it:
- Focus on your overall investment goals rather than isolated risks.
- Ask questions and look for clarity on how options are presented, so you can understand the full picture.
- Work with a professional advisor, as they can help present options in a balanced way, free from any biases.
Overconfidence: trusting your own judgment too much
Overconfidence is the tendency to overestimate your ability, knowledge or control over outcomes. It can lead investors to take unnecessary risks or ignore warning signs, which can in turn lead to losses. Examples include:
- Underestimating risk and believing that your portfolio is immune to downturns, which can result in overexposure to riskier assets.
- Neglecting diversification and having overconfidence in a single type of investment or sector, which can increase concentration risk.
How you can manage it:
- Ask for second opinions from advisors or trusted peers to challenge your assumptions.
- Review your previous decisions to identify patterns of overconfidence.
- Base decisions on evidence and analysis rather than gut feelings.
Working with a financial advisor can avoid emotional investing
A financial advisor can be an invaluable partner in creating and maintaining a financial plan that includes capital preservation as a key strategy. Advisors bring expertise in balancing low-risk investments with assets that outpace inflation (which can protect your purchasing power).
They can also help you navigate complex decisions, such as when to rebalance your portfolio (so you don’t become exposed to too much risk). With professional guidance, you can avoid common mistakes, like being overly conservate or having emotional reactions to market volatility, helping ensure that your wealth remains protected over the long term.
Talk to your IG Advisor about strategies they’re using to help preserve your capital and protect you from emotional investing. If you don’t have an IG Advisor, you can find one here.
Written and published by IG Wealth Management as a general source of information only. Not intended as a solicitation to buy or sell specific investments, or to provide tax, legal or investment advice. Seek advice on your specific circumstances from an IG Wealth Management Advisor.
