Conventional theories are grounded in the assumption that investors make rational decisions. Behavioral finance and emotional investing counter such notion by suggesting that emotions and gut reactions influence investment decisions and we tend to be overconfident in our knowledge, which can be extremely detrimental to our portfolio and long-term investment goals.
Psychology studies reveal that “we should not underestimate the important benefits of the unconscious and its interactive role with the conscious brain.” Financial emotional intelligence brings together our intuitive and deliberate decision-making process. It is substantially directed at aligning our conscious and unconscious by being consciously aware of how our unconscious is affecting our decision making.
The integration of being “conscious” and “unconscious” allows us to avoid irrational thinking. The concept of financial emotional intelligence suggests “take time to reflect our choices, ponder the evidence, and consider how our decisions will affect our emotional state.”
The Cycle of Emotions in Investing
In rising markets, investors are notoriously optimistic; in falling markets that exuberance can quickly fade to pessimism. The cycle of emotions can turn rational investors into irrational ones, tempting us to take drastic action and placing in jeopardy their developed, diversified long-term financial plans.
Understanding the cycle of emotions helps us to manage our response to market fluctuations and remain certain of our financial goals even in times of uncertainty.
The cycle usually starts with optimism, and as stock prices rise, investors start feeling excited, which will lead to euphoria and the belief that the prices will keep heading higher. This is when investors are at the maximum financial risk.
However, prices will not move upwards indefinitely, once stocks decline in value, euphoria gives way to anxiety; if this downward trend continues, anxiety turns to fear. At this point, investors have not only lost prior profits, but some of the initial capital as well. This is when they start to act defensively and think about switching out of riskier assets to more defensive ones.
The more volatile the markets are, the more emotional investors may get about their investing. As a result, panic and desperation set in. Some investors persevere, some capitulate, afraid of further losses.
Being patient at the bottom of the cycle, investors may see an opportunity to own investments with real future return prospects.
Adopt Approaches to Keep Our Emotions Out of Investing
- Begin by adding emotional details and recognizing cognitive issues
- Check our thinking against a list of documented, typical, negative investment behaviors
- Explore how we feel and react in worst case scenarios, the so-called “emotional preparation,” for instance, when the markets are calm, make a list of what you would do if the market gained or lost 300 basis points in one session
- Examine news and tune out noise – our asset allocation should reflect our tolerance for risk, stick to the plan and make adjustments only when the circumstances change, not every time the market changes. Investing should not subject to the constant barrage of information.
- Consult and listen. When our investments lose value, it is fine to feel disappointed, but please keep in mind that decisions should never be made when we feel scared and nervous. Sometimes it is necessary to have someone to monitor and make changes when needed.
- Rebalance – establishing a strategic or dynamic asset allocation and rebalancing holdings regularly.
- Keep your confidence levels in check and be realistic and measured. When looking at historical rates of returns, don’t focus solely on the upside.
- Focus on the long run and the big picture. Anxiety over the possibility for short-term losses can negatively impact our judgment by avoiding potentially higher-return investments.