When emotion gets the best of rational investment decisions

A number of years ago, I fell into the investors trap. I put reason in the back seat and was guided by a mix of fear and emotion.

Less emotion and more reason needed when it comes to a long-term investment strategy
Less emotion and more reason needed when it comes to a long-term investment strategy

It all centered on an Israeli-based company with a truly innovative technology. What made things worse for me in the long run is that I really believed in the technology but was blinded by emotional reaction when it came to making a really good investment choice.

Investors with a skill in the stock market can still be blinded by irrational emotional behavior. In fact, the majority of investors all say they want the same thing: profits.

But this is where things get interesting. When investors say they want profits, that’s a pretty benign goal. Warren Buffet would use this as a means of creating wealth. In his situation, he uses a formula for taking profits and limiting losses and throughout the years, his general formula has work very well indeed.

The difference between Mr. Buffet and the rest of us is that large groups of investors have a lot at stake and get overwhelmed by fear and other emotions which often leads to rational people to make irrational investment choices.

Take the case of “making that profit”. In truth, most investors are not simply chasing a profit, rather, they chasing the maximum profit. Yes, maximum being the operative word.

“What’s the difference” I hear you ask.

A lot!

Here is what generally happens.

Investors purchase a stock (this could also be a mutual fund). Money goes in and now the waiting game begins.

As the stock (or fund) increases in value, there is what I call the intoxication-of-wealth-growth which takes over the investor’s rational mind. Suddenly, that Euro 10,000 has become Euro 12,000 and now, the sky really could be the limit. And, while that stock is in profit, there is a low investor appetite to cash out their gains.

As the growth of the original investment continues, the disconnect between the rational action of taking some of the gains and the irrational choice of staying in and ‘maximizing the profit potential’ rises as values rise. You get the drift. In the case of this investment and return, the investor abandoned their original goal of generating a profit and decided mid-stream to go ‘all out’.

The same is true when prices begin to fall, in fact, it’s probably worse because of the pain of financial loss.

Let’s say our investor again puts in Euro 10,000 and the value rises steadily to Euro 13,000. But within a few weeks, events in the market make the stock less attractive and the future less certain. So, the value of the stock falls to Euro 7500. Here, there is the grip of the eternal and hopeful emotional investor. Instead of using the investment tactics employed by Mr. Buffet and limiting their losses, the hold on in the hope that stock will rise again. The signs of turbulence were there all along which the investor knew but chose to ignore. They don’t have to realise their paper losses just yet because that’s all they are (so far) but the fact that the stock value is now so low eats away at them…it really does feel like they lost money…or worse, that it was stolen. They feel a little silly (an emotional reaction) because they knew that the warning signs were there in plain sight but they chose to ignore them. These could have ranged from interest rate moves, an act of war or a patent dispute.

One major problem that a growing number of investors face is how to handle online access to account balances. While a great resource, it can lead to short-term decisions that conflict with the long-term investment strategies of wealth creation.

For example, the urge to constantly buy into and sell out of stocks can give the investor a feeling that they are limiting their losses and maximizing the potential for gains. However, the trading charges along can negate any value realized and add to the overall level of loss. In this instance, the investor may feel like Gordon Gekko, the fictional character in the movie, Wall Street. In reality, the investor may also be living in a fantasy world and the only real world outcome being lots and lots of trading charges.

This is one of the pillars of successful investing. Long-term strategies can work as long as emotion such as fear are parked. The reason is while many people may have a level of market knowledge and a belief that they can out-perform the stock market average rate of return, the reality is that better returns can be generated through placing their investments in index funds as well as other investment classes (not too risky!) and leaving time do the work for them. This is where they may wish to turn off the daily urge to ‘check-in’ to view the balance amount and leave the system do the work for them.

Anyway, back to my situation. I did actually buy that stock at $20 and it rose to $45. When it began to fall, I sold it at $42.

A few months later, that same stock had fallen all the way back to just under $3. When my investment advisor said that he thought it was a ‘great buy’ I listened but kept my cash out. When the stock rose to $10, I thought ‘damn, missed that one’.

It was only when the stock rose again to $30 that I really thought that I had missed the boat. But, when the stock hit $350 per share, I know I had been duped…by my emotions!

Frank Conway is a financial advisor and runs MoneyWhizz, a financial literacy programme for kids 8 – 18.

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