Paul's Insights: Emotional rescue: Taking moods out of making money
As investors, we all like to think that we're making rational choices. But it's amazing how our moods can drive investment decisions.
Behavioural science comes up with all sorts of explanations for the way we behave as investors.
‘Loss aversion’ for instance, describes the way that investors hate losing money. Sure, this sounds like a no brainer. But it means that even if a share value has taken a big hit – for a good reason, we tend to cling on in the hope that it will bounce back. Sometimes though it can pay to cut your losses and invest the money elsewhere.
‘Representativeness’ is another potential pitfall. It refers to the situation where we see a company we like, maybe because it makes the type of clothing we prefer to wear or the sporting goods we use, and we assume that it will also be a good investment.
Irrational behaviour is part of being human. So too is experiencing a variety of different moods and emotions. What’s really interesting is how our moods can drive the way we invest.
A US study found that bad moods like anger, can encourage increased risk taking. Uncomfortable emotions like embarrassment can also hinder our ability to perceive risk, leaving us vulnerable to making poor investment choices.
Other research shows that when we’re feeling anxious we tend to see a greater level of risk than is really the case.
Even good moods can impact our behaviour.
A high level of excitement makes us underestimate risk and over-estimate our odds of success. That’s why casinos are brightly lit and full of loud noises. It’s designed to get us excited so that we feel more confident about winning.
Human beings are complex, and we lead complicated lives. However, it is possible to keep your investment decisions rational.
One strategy is to invest in a professionally managed fund. The fund manager has no idea about the personal issues you may be facing at work, at home, or in your social life. Instead they make decisions based purely on the aims of the fund.
Another step is to stick to a regular investment routine. That’s where dollar cost averaging is so useful.
All you have to do is decide how much and how often you are going to invest. Monthly, six monthly, or yearly – it doesn’t really matter as long as you stick to the game plan.
The whole point is that dollar cost averaging forces you to buy more when investments are cheap, and buy less when they are more expensive, regardless of what mood you’re in.
Taking the emotion out of your investment choices is achievable. And it can be the key to achieving your long term goals.
Paul Clitheroe is Chairman of InvestSMART, Chairman of the Australian Government Financial Literacy Board and chief commentator for Money Magazine.