Understanding the role of emotions in the financial decisions of investors can go a long way in helping avoid mistakes in stock market transactions
Stock market investors are understandably financially motivated, and it is not uncommon for investors to have strong sentiments about the performance of their stocks, since it is not just their money what is at stake, but also the implications of money in their lives and the ones of their loved ones.
If left unchecked, however, emotions can drive investors to act irrationally or make rush decisions, with substantially detrimental effects on the performance of their portfolios and their investing experience in general. This can turn into a vicious cycle of actions and reactions.
Here are nine investing emotions that would be important to identify, acknowledge, and carefully examine to account for their potential effect on the decisions that stock market investors are likely to face at one point or another, particularly in the case of beginning investors:
1. Unrealistic Expectations
Everyone has heard stories about investors who made a sizable fortune through the stock market, and some people may want to replicate those outcomes with their own investments. In practice, however, the situation may be different. A study conducted by Dalbar in 2001, and repeated in 2015, revealed that the average investor achieved a 5.32 percent return over a 17-year period while the S&P 500 averaged 16.29 percent annually. Why were average investors not able to achieve returns based on overall market performance? Part of the answer may lie in investor psychology, particularly if they lock in their losses without giving their stock picks a chance to recover and reach their growth potential.
2. Limited Patience
Long-term investments are more likely to provide gains than short-term speculation. When the market is down, or when certain stocks are not performing as well as the ones leading the upward trends, those stocks are in many cases regarded with suspicion, and considered to be candidates for selling, even at a loss. This tendency intensifies as the price sinks deeper, which drives some investors to sell very low and lose a significant part of their investment capital in the process. In many cases, if they had simply waited long enough, they would have been able to break even or even sell their stocks for a profit down the road. Unless an investor has an urgent need for hard cash, or believes that the stock will not rebound within a reasonable period of time, the smart move would be to put emotions aside and ride out the downturn.
3. Loss Aversion
For many investors, the losses feel much worse than their gains in the stock market, and therefore may go to great lengths to avoid such losses. Loss aversion stems from a desire to protect oneself against future losses, which may lead them to sell their stocks low and take smaller losses now rather than to risk waiting and losing more money later. The danger with this approach lies in the fact that investors can only lock in their losses or gains when they sell their positions, so by selling low they give up on the chances of stock recovery, particularly in the case of stocks with temporary lows but with significant growth potential in the long run.
4. Price Anchoring
Price anchoring is another important stock market emotion, which refers to the perception that the value of a stock is the one displayed at the moment an investor starts tracking it. Price declines are then perceived as opportunities to buy low, and price gains as an indication that the stock may be getting too expensive. This perception extends to the analysis of stock trends, like in the case of assumptions that past performance will predict future performance, without considering the basics of supply and demand, upcoming competition, company earnings, broader market trends, and recent innovations, among other factors.
5. Peer Pressure
There is a tendency to agree with the opinion of the majority, even when a person would not have arrived to the same conclusion on their own. However, when friends, neighbors or family members talk about how much money they have earned on their investments, it is human nature to want to jump on the bandwagon. After all, if they can make money on those stocks, then you should be able to as well. The same goes for financial commentators on TV and social media, whose opinions can help shape other people’s ideas. If you base your stock buying decisions on the results that others have already achieved, however, there is a reasonable chance that you may not have the same results because the circumstances are different, like the timing of the stock purchase and the specific behavior of the market during that period.
6. Fear of Missing Out
One of the most basic rules of investing is to buy low and sell high. This rule makes sense at the most fundamental level, so why do so many investors lose money in the stock market? One of these reasons relates to the fear of missing out on stocks already displaying remarkable gains, before they get even higher, even at times when those stocks may be close to reaching their upper limits of resistance. When the expectation that such stocks will keep growing is not fulfilled, their faith in them falters, causing investors to sell their positions to purchase the latest rising stocks before they become too expensive.
7. Investment Regret
Buyer’s regret also plays a major role in stock market psychology at times. This often comes into play when an investor perceives that he or she has made a poor investment decision. Given the fact that no investor can accurately and consistently predict how the market will move, all investors will experience loss from poor decisions at some point. Whether you regret jumping on the bandwagon too late, made a poor projection, or have regrets based on other factors, this issue has a tendency to repeat itself and lead to more regrets. Buyer’s remorse can lead investors to cut their losses even if they end up losing money in the process.
8. Financial Stress
The pressure to reach positive returns on an investment may be felt with particular intensity by those who are increasingly falling behind in their efforts to reach their financial goals, like those looking to retire while maintaining a certain lifestyle, are burdened by high levels of debt, and for those who have already lost money on other investments. This may prevent investors from carrying out their financial analyses with the necessary peace of mind, since their decisions may be significantly influenced by a strong need for positive results.
9. Overreaction Tendency
Optimism and pessimism affect investor psychology as well. For example, when investors hear great news about a company, they may tend to overreact based on the belief that the news will have a positive impact on the business. Likewise, negative news may result in extreme pessimism that often causes investors to overreact in the other direction, leading investors to sell their positions at a loss. The result is significant short-term price swings that may not be directly related to the actual growth potential of a given stock.
Financial discipline is crucial to the process of handling investing emotions. Successful investors understand stock market psychology, and train themselves to identify their emotional impulses and address them with a critical eye. Decisions to buy, sell, or hold stocks should be systematically informed by market analyses, and savvy investors will take the time to review their potential trades to ensure consistency with their overall investment strategy.