Most investors buy and sell stocks based on emotions rather than cold, hard evidence. You may want to believe trading is based on objective information and keeping an eye focused intently on your investment goals.
But you’re only human.
You may have been influenced to purchase a stock because you saw a talk about it on social media. You may sell a stock because it’s lost some value and you’re in panic mode. You’ve probably bought or sold stocks just because it feels good to make a transaction. All these actions stem from what industry experts refer to as market sentiment.
Even if you haven’t traded based on emotion, there may be other instances where you didn’t make the optimal investment choice due to a lack of information.
Behavioural finance is a new field of study that examines this phenomenon. It looks at psychology and emotion and seeks to explain why markets don’t always go up or down the way we might have predicted.
Conventional or Traditional Finance
People have been studying finance for years. As a result, many theories and models use objective data to predict how markets will respond under certain circumstances. But these models make false absolutes, such as:
- Investors always having complete and accurate information at their disposal.
- Investors have a reasonable tolerance for risk, and that understanding does not change.
- Investors will always seek to make the most money at the highest value.
- Investors will always make the most rational choices.
As a result of these assumptions, conventional finance models don’t possess a perfect track record. Over time, academics and finance experts began to notice anomalies that conventional models could not explain.
If investors are behaving rationally, certain events should not happen. But they do.
There is no rational explanation for these occurrences, but human behaviour can explain them. Consider the so-called, “January effect” which suggests that many stocks outperform during the first month of the year. No conventional model predicts this, but studies reveal that shares surge in January because investors sold off stocks before the end of the year for tax reasons.
Accounting for Anomalies
The human psychology is complex, and it’s impossible to predict every wrong move investors might make. But, those who have studied behavioural finance have concluded that many thought processes push us to make less-than-perfect investment decisions.
These are evidenced by:
- Attention Bias: There is evidence suggesting that people will invest in companies that are in the headlines, even if lesser known companies offer the promise of better returns. Who among us hasn’t invested in Apple or Amazon, simply because we know all about them?
- National Bias: A Jamaican is going to invest in Jamaican companies, even if stocks in the Caribbean offer better returns.
- Under-diversification: There is a tendency for investors to feel more comfortable holding a relatively small number of shares in their portfolio, even if wider diversification would make them more money.
- Cockiness: Investors want to believe they are good at what they do. They aren’t likely to change investment strategies, because they have confidence in themselves and their approach. Similarly, when things go well, they are likely to take credit when it fact their good results come from outside factors or sheer luck.
How It Can Help You
If you want to become a better investor, you will want to become less emotional. That sounds harsh, but it will benefit you to take stock of your own biases and recognise where your faulty thinking has hurt you in the past.
Consider asking yourself tough questions, like, “Do I always think I am right?” or “Do I take credit for investment wins and blame outside factors for my losses?” Ask, “Have I ever sold stock in anger, or bought a stock based on a simple gut feeling?”
Perhaps most importantly, you must ask yourself whether you have all of the information you need to make the right investment choices. It’s impossible to know everything about a stock before buying or selling, but a good bit of research will help ensure you’re investing based on logic and objective knowledge rather than your own biases or emotions.
If you want to start investing with SSL but don’t have the time to monitor the market or to conduct the trades yourself then you can choose one of SSL’s managed Financial Planning products. We offer a variety of products for every type of investor and if you are interested in managing online trades yourself and having complete control over your investment portfolio then you can try SSL’s Brokerage account.