When emotions bump into investment choices, the danger is we get spooked when markets fall and sell our holdings, turning a paper loss into a real loss because we let fear get the best of us.
Or conversely, when markets are flying, greed keeps us invested because it may still have further to go.
Of course, this is where a financial adviser comes in, helping prevent investors who might otherwise act on their emotions from making a bad decision, by steering the best course in a falling or fast-rising market.
However, recent comments from Morningstar’s director of behavioural science Sarah Newcomb suggest being too rigid in the application of logic and maths to investment decisions could be doing a disservice to investors. After all, how we choose to invest, when we invest and the result of our investing can all have a direct impact on our sense of wellbeing.
For example, one of the biggest financial decisions we will ever make is buying a property. We all know that financial sense should take precedence here given the size and length of the commitment, but often the choice of property bought will be made as much with the heart as the head.
But it does not stop there. More of us are now keen to invest according to our beliefs, and the resulting surge in the number of environmental, social and governance funds is proof that emotion is increasingly playing a part in our investment decisions.
Having more time on our hands thanks to lockdowns and furlough during the pandemic has given us extra time to look at our investmentsTwo decades ago, green or ethical investing would have been considered a fringe activity. But not only did almost half of ESG funds outperform their benchmark index last year according to data from Morningstar, it was also those ESG funds presenting lower risk to their investors that performed the best.
Now, let us be fair, 2020 was a far from ‘normal’ year in every sense, but this does prove that investing with a conscience can also help your wallet. Here, at least, there has been a distinct advantage in your emotion and investments being intertwined.
Having more time on our hands thanks to lockdowns and furlough during the pandemic has given us extra time to look at our investments, and to explore new and different ways to invest. Hargreaves Lansdown has seen 6m trades on its platform in the first four months of the year, up from 4m in the same period last year. The multi-asset platform eToro saw its trading volumes rise 233 per cent in the first quarter of this year compared with the same period last year. This suggests people are using shorter-term trading strategies.
Usually, shorter-term trading is not a good investment strategy, but some of this will be driven by our compulsion to look for opportunities in volatile markets rather than spending time in the market and using other, steadier investment methods to invest, such as pound-cost averaging.
The emotions involved in the first of these methods are greed and fear – powerful drivers that can result in heavy losses or considerable gains depending on how your specific investment goes. The latter requires a more relaxed approach with far less emotion attached, which has been proved time after time to provide better longer-term results.
Yet the point about investing and emotion needing to be separated can be applied much more widely than this. It is not all about making hot-headed decisions as you see markets swing wildly.
As Newcomb points out, the association between money and what it allows us to do or how we feel is almost impossible to completely obliterate and, more importantly, it perhaps should not be. For an adviser, understanding the emotional position clients are coming from when considering an investment is pivotal to determining whether it is right for them.
There is no doubt the ‘attitude to risk’ scoring questionnaires will go a long way towards helping you and your clients to understand the amount of risk they are prepared to take. But they can feel a relatively blunt tool that may not encapsulate the emotional reasons we invest.
For example, is a parent looking at investing to build a comfortable future for the family? Is the investment to pay for school fees? For retirement? For a dream holiday? A rainy day?
All of these are wrapped up in some type of emotion, and advisers failing to appreciate this are not giving their clients the best of themselves. Maths, logic and facts will only take you so far, unless you happen to be a Vulcan.
Money does not make the world go around, no matter what the song says. But we cannot deny that having it makes the ride more comfortable. And that is the key point to all of this.
Separating emotion and investment can only go so far before it fails to keep pace with our own reality. So, advisers need to be sure they are addressing both the emotional and investment needs of their clients with their advice, even if these are not obvious without a little digging.
Alison Steed is a freelance journalist
