Do investors rely on emotion when investing? Many behavioral economists and psychologists believe they do.
As much as we recognize the need to save, many small obstacles tend to get in the way. It turns out the decisions we make about financial matters are deeply rooted in emotion. For example, one often cited study shows that investor sentiment is most positive leading up to a peak of exuberance, then moves more negative on the way down before the pattern repeats.1 Oddly enough, we feel the happiest when we are at the point of highest risk in the market (when markets approach or surpass previous highs) and most anxious when the upside is greatest (at or near market lows).
There’s no single rule that neatly connects market volatility and investor behavior. But most psychologists agree that fear is stronger than greed. One theory developed by Daniel Kahneman, a Nobel-winning professor at Princeton University, suggests that our decision-making processes rely on intuition and relative-value judgment.
Professor Kahneman devised a series of experiments that illustrate that investor losses hurt more than gains feel good —the pain of losing $100, for example, was shown to be twice as great as the pleasure of winning the same amount.2 This may help explain why we have a tendency to sell winning funds too early, and avoid losses altogether—even if it means choosing not to participate in potential gains.
That’s why it’s critical not only to have an investment plan that matches asset allocation to your objectives, time horizon and risk tolerance, but also to envision ahead of time how you might react to market ups and downs. Managing your emotions, and knowing how to remain flexible and resilient when times get tough, can help you weather inevitable financial storms that arise.
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1 “Cycle of Investor Emotions,” Behavioural Finance, Barclays, 2006. https://wealth.barclays.com/en_gb/home/research/research-centre/white-papers/Behavioural-Finance/Cycle-of-investor-emotions.html
2 Kahneman, Daniel, and Amos Tversky. “Prospect Theory: An Analysis of Decision under Risk,” Econometrica, XLVII (1979), 263-291.
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