Emotional Decision Making

Emotional Decision Making

Investing can be an emotional endeavor, especially during a period of changing market climates. Recognizing investor’s emotional biases is the first step towards rationalizing ones decision making and maintaining proper focus on long-term goals and investment strategies. So, what are the most common emotional biases?

One common emotional bias for investors is recency bias, the expectation that recent investment trends will continue into the future. In other words, investors tend to project their current mood into the future. They don’t see how things could deteriorate during a good market, so they buy high. Or, they don’t see how things could get any better in a down market, so they sell at a loss.

For example, out of the ten largest equity inflows since 1998, two occurred at the peak of the tech bubble and two were at the peak of the bubble preceding the financial crisis. Of the ten largest equity outflows, one occurred during the bottom of the tech bubble, and two occurred near the bottom-point of the financial crisis.

By maintaining a long-term investment plan that de-emphasizes short-term fluctuations, investors can focus on their short-, medium-, and long-term goals and not their monthly account performance.

Another emotional phenomenon is loss aversion, or the preferences of those who seek to avoid losses more than they wish to acquire gains. A famous experiment by cognitive psychologists Daniel Kahneman and Amos Tversky showed that participants disliked losses 2 to 3 times more than they enjoyed gains. For example, the average person would be more upset if they lost $20 than they would be happy if they had found $20.

Inside Edge Capital focuses on helping clients decide their level of investment risk through both conversations with you and by utilizing innovative industry tools. This technology is dynamic in that it forces people to answer the difficult question that many investors refrain from ever answering themselves: “How much risk am I capable of handling?”

Knowing that everyone reacts to drops, corrections and crashes differently, we can get ahead of this question to help clients express and understand what their loss threshold is. Seeking to align a client’s portfolio risk with their personal risk tolerance allows our clients to feel comfortable with their expected investment outcomes during any market environment.

A third common emotional bias is anchoring, or placing undue emphasis on a single point of reference. For example, many investors were focused deeply on recent presidential elections. While some were terrified by the results, others were euphoric. An investor’s personal situation, balance sheet, cash flows, portfolio diversification and many other variables should be viewed as more important to how one is investing versus who is the president. However, this single point of reference can skew emotions and decision making.

There are many types of emotional biases that exist in investing that advisors must take into account. Many investors are susceptible to being driven by emotions they believe will help rationalize the markets. 

So let’s keep the lines of communication open and flowing, so that we can help you navigate investment markets.