Emotional investing is costing you money – here’s what to do about it
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Behavioural finance experts Oxford Risk say emotional investing costs investors around 3 per cent in lost returns a year over the long-term. And in the current wild stock market environment, it could be lot higher.
‘Emotional investing’ involves people impulsively buying and selling stocks and investments on the back of markets rising and falling.
This often leads to people piling into investments when markets, stocks or asset classes are high, and selling when they are low.
That is the opposite of what investors should be doing.
We currently have the perfect storm for emotional investing, Greg B Davies, PhD, head of behavioural finance at Oxford Risk says.
“The current economic, fiscal and stock market environment, plus the recent rise in crypto-assets valuations and retail trading, has created a situation where the risk of emotional investing has hit a new peak,” he says.
“Investors frequently pursue investments that are familiar, for example companies that are highly publicised in the media, and those that have recently announced large gains.
“This is because in times of stress investors find emotional comfort in investments which they hear about regularly, and which offer the promise of short-term returns.”
The rise in the value of Bitcoin has also led to a crypto-assets ‘gold rush’, with retail investors piling into an incredibly volatile asset class that most don’t understand, Davies says.
“The pandemic means many investors are currently highly emotionally sensitive and have a shortened emotional time horizon which increases the appeal of get-rich-quick gamble,” he says.
We’ve all heard stories of people who panicked during a downturn, went to cash, and then lost out when the market recovered.
“For those investors who have increased their allocation to cash during these volatile times for markets, Oxford Risk estimates that the cost of this ‘reluctance’ to invest is around 4 per cent to 5 per cent a year over the long-term,” it says.
“In addition, it estimates that the cost of the ‘Behaviour Gap’ – losses due to timing decisions caused by investing more money when times are good for stock markets and less when they are not – i.e., buy high and sell low – is on average around 1.5 per cent to 2 per cent a year over time.”
Humans are complex beasts, with some investors having far higher risk tolerance than others. This means mitigating emotional buying and selling mistakes usually requires a tailored approach.
But Morningstar says it is possible to address the risk of emotional selling more generally by:
Confirmation bias is the tendency to seek out info that supports an existing conclusion.
“Confirmation bias is a major reason for investment mistakes as investors are often overconfident because they keep getting data that appears to confirm the decisions they have made,” says Magellan Group.
“This overconfidence can result in a false sense that nothing is likely to go wrong, which increases the risk of being blindsided when something does go wrong.”.
There’s a bunch more examples of cognitive biases that can lead to investing mistakes here.
There’s also an ASX_Bets version ‘How To Avoid A FOMO Buy In 10 Steps‘.