By Gustav Andersson
Emotional Investing and Behavioral Finance
Emotional investing occurs when people make decisions based on their feelings instead of analyzing the facts and carefully considering their strategy. This is related to the field of behavioral finance. Which study how people’s thoughts and emotions influence their investing choices (Ricciardi & Simon, 2000).
Investors can fall into traps that lead them to make illogical choices. According to Pompian (2011), some common traps are:
Overconfidence: An investor who takes on unnecessary risk, pouring money into hot industries in which the investor has no expertise or investing heavily in a single company.
Herding: Following what everyone else is doing instead of thinking for yourself. Loss aversion: We hate the feeling of losing more than we love winning. Investors hold onto bad stocks for too long, afraid to take a loss, and miss out on better opportunities. Don’t be afraid to break up with a bad investment. Don’t marry your invested company!
Confirmation bias: Only paying attention to information that agrees with what you already think.
These mental traps can lead investors to make emotion-driven decisions that don’t align with a smart, long-term plan. Lo et al. (2005) studied day traders and observed that their emotions, like fear or greed, often led them to make impulsive, irrational trades.
A real-world example of emotional investing occurred in the late 1990s dot-com bubble. Investors got overly excited and invested money in tech stocks because they didn’t want to miss out on making huge returns. When the bubble eventually burst, these emotional choices led to personal financial disasters (Pompian, 2011).
By understanding how emotions can drive investing and what behavioral finance teaches us, investors can work on making more logical, long-term choices through a more disciplined approach to investment decisions.
Strategies to Avoid FOMO and Emotional Investing.
To minimize the impact of FOMO and emotional investing on your financial decisions, consider implementing the following strategies.
- Reduce FOMO: Minimize social media use: Constantly comparing your investments to those of others on social media can fuel feelings of FOMO. Set boundaries on your social media consumption to reduce exposure to investment-related content that may trigger emotional responses. You rarely see people talk about their losses, even though social media contributes to many good discussions. Consider turning off the faucet.
- Know Your Limits: Assess your risk tolerance – how much volatility are you comfortable with? Allocate your investments accordingly, remembering the golden rule – don’t invest what you can’t afford to lose! (Diversification) Think about your goals (like retirement or a house down payment) and choose a mix of investments that reflects your risk tolerance.
- Embrace diversification: Spread your investments across various asset classes, sectors, and geographic regions to minimize the impact of any single investment’s performance on your overall portfolio. (rational choices, Diversification) Consider index funds or ETFs: These investment instruments offer broad market exposure and can help mitigate the temptation to make emotionally-driven decisions based on individual hot or hyped stocks. (rational choices)
- Maintain a long-term perspective: Avoid short-term thinking: Discipline yourself to focus on your long-term goals. The market will have ups and downs, but short-term dips don’t matter much if you’re staying invested for the long haul. Stay in the pocket and bob and weave through the ups and downs like Mike Tyson, eyes on the prize. Ignoring the market noise: Limit your exposure to financial news and commentary if that may trigger emotional responses or encourage impulsive decision-making. (Discipline)
Seek professional advice: A qualified professional such as a financial advisor or a stockbroker can provide objective guidance. Help you develop a personalized investment plan.
By implementing these strategies, you can work towards minimizing the impact of FOMO and irrational investment decisions. Remember that building wealth is a long-term process, it’s a marathon NOT a sprint. Staying committed to a rational, disciplined approach is key to achieving your goals.
The Benefits of Overcoming FOMO and Emotional Investing.
Staying committed to a long term investment plan will not only make you sleep better, eat better and live better. Reflections and commentary from the blogger: Reducing the influence of FOMO on your investment decisions can lead to significant improvements in your overall mental health and well-being. When you’re not constantly comparing your investments to others or worrying about missed opportunities or investment losses, you’ll experience less stress and anxiety. This newfound peace of mind can extend beyond your financial life, positively impacting your relationships, work performance, and overall life satisfaction.
Moreover, by practicing mindfulness and developing a more balanced perspective on your investments, you’ll cultivate a healthier relationship with money and time is money, don’t be disrespectful to yourself! This shift in mindset can help you focus on the aspects of life that truly matter to you, rather than getting caught up in the endless pursuit of financial gains.
Now let’s throw in a couple of facts to prove the point!
Better Financial Outcomes: Research has shown that investors who maintain a disciplined buy-and-hold strategy tend to outperform those who frequently trade based on emotions or attempt to time the market. For example, a study by Dalbar, Inc. found that over a 20-year period ending in 2020, the average stock fund investor achieved a 5.96% annualized return, compared to the S&P 500’s 7.43% return during the same period. This underperformance can be largely attributed to emotionally-driven buying and selling decisions (Kinnel, 2021).
By sticking to a well-defined investment plan, diversifying your portfolio, and maintaining a long-term perspective, you can avoid the pitfalls of emotional investing and improve your chances of achieving your financial objectives.
Overcoming FOMO and emotional investing is a powerful step towards improving both your mental well-being and your financial success. By developing a healthy relationship with money and adopting a rational approach to investing, you can unlock the full potential of your financial resources while finding greater contentment in your personal life.
References: Kinnel, R. (2021, March 15). Quantifying the Impact of Investor Behavior on Returns. Morningstar. https://www.morningstar.com/articles/1031162/quantifying-the-impact-of-investor-behavior-on-returns Przybylski et al. (2013): https://www.sciencedirect.com/science/article/abs/pii/S0747563213000800 Hayat & Anwar (2020): https://link.springer.com/article/10.1007/s10942-020-00372-1 Pompian (2011): https://www.wiley.com/en-us/Behavioral+Finance+and+Wealth+Management%3A+How+to+Build+Optimal+Portfolios+That+Account+for+Investor+Biases%2C+2nd+Edition-p-9781118182291 Ricciardi & Simon (2000): https://papers.ssrn.com/sol3/papers.cfm?abstract_id=256754 Lo et al. (2005): https://www.aeaweb.org/articles?id=10.1257/000282805774670095
Overcoming FOMO and emotional investing is a powerful step towards improving both your mental well-being and your financial success. Have you ever struggled with emotional investing? Share your experiences and tips in the comments below!
Next up: Investing for the Win: Part 4 Building a Strong Investment Strategy