Emotion-based investing: What is it and how can you avoid it?

Have you ever made a snap decision to sell your shares in response to short-term market fluctuations and volatility? Or have you rushed to follow a new investment trend for fear of missing out?

If so, you may have been engaging in “emotion-based investing”. This means making decisions based on emotions rather than logic and data.

According to research by Barclays, half of investors admit to making impulsive investment decisions – based on emotions such as excitement, impatience, and fear – and then regretting it.

Learning how to recognise and avoid emotional investing could help you keep your financial plan on track.

6 signs you’re making investment decisions based on your emotions

There are several red flags of emotion-based investing, including:

  1. Impulsive reactions – Such as selling or buying investments in response to short-term market fluctuations.
  2. Poor risk management – Failing to give due consideration to risk, taking on excessive risk, or adopting a highly risk-averse approach.
  3. A narrow focus – Investing in a single sector or asset class due to personal preferences or emotional biases.
  4. Overlooking key information – Such as a company’s financial health and market position.
  5. Following the herd – Chasing investment trends rather than following your long-term investment plan.
  6. Trying to time the market – Attempting to sell your investments before they fall in price and buy them back just before they rise, which is often a recipe for losses.

If you notice yourself engaging in any of these behaviours, there are several steps you could take to adopt a more logical approach and get your financial plan back on track.

How you could avoid emotion-based investing

It’s natural to feel excited about a new investment opportunity or apprehensive about a downturn in the markets. However, letting your emotions drive your investment decisions could make it harder to achieve your financial goals.

Fortunately, there are ways to keep your emotions in check.

Focus on your long-term investment goals

Taking a long-term perspective on your investments could help you avoid being swayed by short-term fluctuations in the market.

Remember that market volatility is inevitable – markets will move up and down in the short term. Accepting this and focusing on your long-term goals could reduce the risk that you’ll respond impulsively to any short-term changes in the value of your investments.

Additionally, long-term investing could allow your portfolio to benefit from compounding – when your returns generate more returns. This can have a snowballing effect over time, helping your investments to grow.

However, creating a personalised investment plan that effectively balances risk and relies on data rather than emotion-based decisions may not be straightforward, especially if you’re a beginner.

A financial planner can help you understand your attitude to risk and assess investment opportunities objectively. This could help you tackle emotional biases, such as risk aversion, or conversely, a tendency to take on too much risk.

Recognise your cognitive biases

A cognitive bias is a tendency to think and reason in an illogical way. We may create a subjective reality by over-simplifying ideas, ignoring evidence that conflicts with our beliefs, or otherwise making illogical decisions.

There are many types of cognitive bias that may result in emotion-led investment decisions, such as:

  • Overconfidence
  • A tendency to seek out information that supports your existing opinion (confirmation bias)
  • Loss aversion, in which you feel the pain of losses more acutely than the pleasure of wins.

Allowing such biases to inform your decisions unchecked could potentially harm your investment returns.

Everyone has biases and it may not be possible to eradicate them. But you can work on becoming more aware of your biases and preventing them from disproportionately influencing your investment decisions.

Diversify your investment portfolio

Emotional investors often focus on a particular investment they are interested in or feel comfortable with. This could potentially increase your level of investment risk.

For example, if you invest solely in green energy, your entire portfolio could be negatively affected by a downturn in this sector.

Conversely, diversifying your portfolio could help to protect your investments against the potentially damaging effects of market fluctuations. By owning multiple assets that are likely to perform differently at various times, you could reduce the overall risk of your portfolio.

As an example, according to figures reported by JP Morgan, the UK FTSE All-Share Index fell by 9.8% in 2020. So, had you invested all your money in the UK that year, you’d likely have made a loss.

In contrast, the US S&P 500 rose in value by 18.4% in 2020. So, if you’d spread your investments between the UK and the US, you could have offset some or all of your UK losses with gains made in the US.

Avoid checking your investments too often

With the ready availability of investing apps, it’s never been easier to check how your portfolio is performing.

A growing number of people are taking advantage of this opportunity. A report by CNBC found that 49% of investors check their portfolios at least once a day.

However, frequent checking of investments could lead to stress and a higher risk of emotion-based decision-making.

So, instead of absorbing yourself in the inevitable ups and downs of the market, try to stay focused on your long-term investment plan.

Seek advice from a financial planner

A financial planner can monitor your investments and give you updates as and when necessary, saving you the time and stress involved in obsessive checking.

They can also act as an objective sounding board and help you make decisions based on data and logic, rather than emotions.

Read more: 5 useful ways a financial planner can help you manage you investments

If you have further questions about how to avoid emotion-based investing and would like help developing a long-term investment strategy that aligns with your goals, we’d love to hear from you.

Please get in touch either by email at helpme@aspirellp.co.uk or by calling 0117 9303510.

Please note

This article is for general information only and does not constitute advice. The information is aimed at retail clients only.

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.

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