Investing based on emotions or instincts is a difficult issue.
So challenging that an entire field, Behavioural Finance, examines how investor psychology and emotions affect investment decisions.
Recently I read an article where the author believes that financial planners prefer clients with little investment knowledge. That way, it is easier to sell them whatever you want.
Yes, there are financial planners, brokers, etc., that operate this way. But in my experience, good financial planners would rather deal with well-educated investors.
And often the reason relates directly to emotional investing.
Rational Investors Are Better Investors
Investors who better understand the investment process have an easier time investing rationally. Investors who appreciate modern portfolio theory. The concepts of diversification, asset correlations, investment risk, asset allocation, etc.
By knowing the underlying principles behind successful investing, investors can make more rational and appropriate investment decisions.
A decent Investment Policy Statement should incorporate these aspects. It will help keep the investor focussed on the big picture. Especially during turbulent times.
The Investment Policy Statement allows investors to examine their unique personal circumstances and then create an asset allocation strategy that meets their investment objectives and constraints.
What Jim Cramer or the other media talking heads are screaming through the television play no part. Nor does the investment that made your sister-in-law some money five years ago.
Unfortunately, the vast majority of investors (yes, even many “sophisticated” ones) get caught up in this sort of emotional investing.
These investors want to fill their portfolios with the flavour of the day. The same investment everyone else is chasing. The end result usually is a bursting investment bubble.
Or they focus on past successes that may no longer be suitable in today’s world.
Are Your Investing Decisions Based on Emotions or Instincts?
The Vanguard Group offers a short video addressing this question. It is well worth watching.
Key comments in the video, include:
One of the biases that behavioral finance talks about is this selective attention to information: That in making a decision, you’re only listening to really confirmatory views about what you already believe.
Selective attention, also called “confirmation bias”, is a problem for many investors.
If you are simply looking for positive reinforcement on a decision that you have already made, feel free to “research” in this manner. But if you are truly trying to arrive at the optimal conclusion, keep an open mind. Consider all information, even if it does not coincide with your preconceptions.
be very careful about predicting the recent past, the information you have about the recent past, to the future.
Yes, trends can occur over time. Strong management today may continue in the future. Companies with monopolies yesterday may also have monopolies tomorrow. So look to the past for clues as to future events. That is much of how one researches investments.
But do not automatically assume that past events will continue. Sadly, this is another problem with many emotional investors.
Circumstances shift over time and their impact on investments change. Gold has performed very well in recent years. But has it reached a peak or will its relatively high returns continue?
Just because gold has performed well in the past does not mean it will continue to do so. You need to examine factors today to assess how they will impact future results.