How Emotions Influence Investment Decisions

When we scrutinize our stock holdings, many of us might find a few losing counters that have been there for a long time. One of the many reasons why we still hold on to these counters is simply because we are hoping that one day its price will go up and we can then sell them off. In theory, we know that there should be a limit to trigger us to sell off these counters when our investment value falls below our minimum limit. However, in reality, we procrastinate for as long as possible as at the back of our head, our mind is telling us to wait. At the end of this article, you will be able to identify how emotions affect our investment decisions.

 

Traditional investment theory is based on the assumptions that investors will be rational in arriving at their investment decisions. Unfortunately, whilst we understand the need to be prudent in our investment, act reasonably and make our investment decisions based on all available information and objective analysis, most investors are always influenced by their emotional state when they decide to buy or sell their investment holdings.

 

Positive emotion versus Negative emotion

It is human nature that we react differently when we are in a different state of emotion. In the book ‘Inside the Investor’s Brain’, written by Richard L. Peterson, research has shown that when people are happy and satisfied with their life, they tend to be more confident with the decisions that they make. Their decision making process becomes simpler. They will be less involved in the minute details in information gathering, able to ignore irrelevant information, be willing to consider fewer dimensions and use less time to decide on what they want to invest. Optimistic people tend to take on more risk when faced with moderate stake. However, given a high risk and high gain situation, they will forego the potential to gain in order to avoid the risk of losing their current state of happiness.

 

On the contrary, when people are in negative state of mind, they become very suspicious and indecisive. They will try to use whatever information that they can get hold of to analyze their investment decisions in order to avoid taking even the smallest risk,  and end up over analyzing information which will lead to them making the wrong decisions. They are paranoid over every small loss that they make and take a long time to get over any failures. It is the fear of regretting any wrong decisions that make them hold on to their losing stocks. However, given an opportunity of high return, they are willing to take the high risk with much hope of pulling themselves out of their current state of despair.

Nonetheless, reactions triggered by positive or negative emotions are not all the time clear cut. There are times when both positive and negative emotions produce similar results. Research has shown that when emotions involve a sense of certainty - such as anger - the emotions will then lead people to feel that they have more control over the outcome, causing them to be more willing to take risks. For example, if an investor had just experienced losses in an investment which he feels was because of inappropriate advice from his financial adviser, common sense dictates that he will most likely take charge of analyzing his own investment risk in his future investment himself. On the other hand, if a person experienced failure in his previous investment and felt that it was due to his own inability to read the market, then he will probably dwell in his previous bad experience and become more analytical in his analysis before he is able to make new investment decisions.

 

 

When investors are emotional, they are also prone to think that their current state will continue into the future. For example, if an investor is currently earning huge profit from his high risk investments, it will be unlikely for him to diversify into less risky investments as he will be feeling confident in his investment acumen. On the contrary, an investor who gets burned badly in the market downturn will hesitate to invest even though there are signs of recovery as he will be thinking that these signs are just temporary phenomena to entice gullible investors.

 

As humans, we are bound to be influenced by our emotions. Therefore, we have to learn to detect the emotions that are affecting us those which could cloud our investment decisions. We may not be able to isolate our investment decisions from our emotion, but by knowing what is bothering us, we can take logical steps in minimizing the impact it makes to our decision making process.

 

 

Brought to you by Securities Industry Development Corporation (SIDC), the training and education arm of the Securities Commission Malaysia, as part of its ongoing efforts to create well-informed and savvy investors in the capital market. The information provided in this article is for educational purposes only and should not be used as a substitute for legal or other professional advice. For more information, log on to www.min.com.my, call 03-62048889 or visit our Facebook page at www.facebook.com/PelaburMalaysia

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