Many people make basic errors when it comes to investing which could have been avoided if they had stripped the emotion out of their decisions.
According to many of the world’s most respected investors and academics, the majority of this heartache is caused by the human brain and the simple fact it’s not correctly wired to deal with stock markets.
In the 1960s, Nobel Prize-winning economist Eugene Fama stated markets were efficient and investors made rational decisions.
However, several market crashes and scandals later, many financial theorists were beginning to think psychology might have more of an effect on the way people invest than had been originally believed.
In 1985, financial professors Werner De Bondt and Richard Thaler published an academic article in The Journal of Finance, which said people systematically over-react to geopolitical events, news stories and anything unexpected, which results in a substantial impact on stock markets at home and abroad.
This has been cited by Martin Sewell at the University of Cambridge, among others, as the start of studies into what has become known as the field of behavioural economics, or behavioural finance.
Over the past few decades, many experts in the field of behavioural finance argue the complex and highly emotional process of staking our financial future on a portfolio of companies triggers the reflexive system of the human brain.
In short, this process subsequently prompts investors to take irrational decisions, including panic buying and selling shares, overtrading, refusing to budge on preconceived ideas and blindly following whatever we’re told to believe.
This worrying conclusion hasn’t been lost on the big name investors of past and present generations. The likes of Warren Buffett, founder of Berkshire Hathaway, are known for devising various unconventional strategies in a bid to detach themselves from the emotional rollercoaster of equity investing.
But while keeping one’s emotions in check sounds like a fairly simple task, countless stories of people continually getting burnt by giving into them indicates few in the game have been sufficiently able to master what the experts frequently refer to as the basic rules of investing.
Rule 1: Don’t fall in love
One way to avoid emotional bias is to not fall in love with any particular investment. Be objective and focus on the numbers, not the back story. For Steve Davies, manager of four Jupiter growth funds and investment trusts, one of the most obvious pitfalls is falling excessively in love with a company after a period of successful returns.
“The warm feelings you have towards the company and the people running it are hard to overcome, and it’s always easy to find reasons not to sell and move on,” he warns.
To combat the risk of holding onto stocks for too long, and identify new opportunities, many managers and brokers formulate ‘target prices’ at which they will sell or top-slice holdings.