The Role of Emotions in Investment Performance

Many people compare investing to gambling, primarily due to the uncertainty regarding result production in both activities. However, the fact that emotions play a massive role in the decision-making process in similar degrees in these two endeavors cannot get ignored.

While in games of chance, gamblers bet on hunches or thanks to superstitions. In investing, investors make choices chiefly based on information and advice. Yet, one is not to underrate the part that intuition and emotions have in this wealth-building venture.

Everyone knows that anger can lead to impatience and rash judgments, whereas being afraid can cloud one’s acuity via caution and doubt. On the other hand, excitement can force an individual to swiftly decide on something without considering its implications in total.

Hence, feelings can undoubtedly be a person’s worse enemy. Per the renowned American political scientist Herbert Simon, – “to come close to anything resembling a complete theory of rationality, we must grasp what component emotion plays in it.”

Naturally, its influence is expectedly vast. According to a 2014 four-institutional study published in the Annual Review of Psychology, emotions constitute predictable, potent, pervasive, and part-time beneficial or harmful drivers in decision-making.

They can take the form of incidental or integral influences. And although not classified as a form of heuristic thought, some can trigger a systematic one that can elicit rapid action. Seeing as emotions are an integral part of every human.

There is no circumventing their impact in the investment sphere also. The limbic system, the brain area responsible for behavioral and emotional responses, also fires up when motivation, memory, and instincts get activated, called up for investment purposes.

There, bias adds its spice to decisions, and this concoction may make investors trade in states of euphoria or offload securities at discounted rates in corrective periods. How and why that happens gets explained below.

Types of Emotional Biases in Investing

What is an emotional bias? It is a distortion in cognition brought upon specific feelings one may experience or various emotional factors.

For instance, a person can believe that something has a positive effect on their well-being because this idea of this generates a pleasant feeling, despite evidence that the contrary is accurate.

Everyone has biases. That is a fact of life. These inclinations or prejudice exist because they form through everyone’s past experiences. Everyone has different ones, so people’s views will inevitably favor specific things.

The etymology of this word derives its origin from French, meaning a slant or slope.

Various types of biases are often get mentioned relating to investing. The three more popular ones in this field are low-aversion bias, overconfidence bias, and endowment bias.

Low-aversion refers to situations where investors hold on hope for too long that stocks in a portfolio that have gone down too much will bounce back, and they do not sell in time.

Overconfidence bias is pretty self-explanatory, and it means that a trader holds a sizable belief in their skills, viewing them as superior to the competition, operating with the notion that he has an edge others do not possess.

Endowment bias is somewhat similar to the loss-aversion kind, as this is the concept that what we have is worth more than what we do not.

Note that biases can also get influenced by academic and social norms, assumptions, and more. In general, they are often more ingrained in the psychology of investors than those of the cognitive type and are, as a rule of thumb, harder to overcome.

Though, they usually occur spontaneously and are rarely a result of expansive conceptual reasoning.

Other emotional biases tied into investing worth mentioning are the status quo bias, or the tendency to stick with what we have, then regret aversion, avoidance of taking actions, self-control, the ability to override urges, and the optimism bias, linked to the illusion of control, or overconfidence.

Effects of Emotional Biases on Investment Performance

Past performance is no indication of future results. In that lies the gambler’s fallacy, the false notion that if a gambler is on the wrong end of multiple losing rounds, he is due for a win.

Still, in trading, one must look at the past when trying to guess the future accurately, and when doing so, traders lean on several well-regarded investment performance reporting metrics.

These include the Beta, the R-square, the Sharpe and Sortino ratios, the standard deviation, and the portfolio return vs. benchmark measure, to name a few. These are only the most established tools for portfolio evaluations.

Choosing the methods in assessing how one’s trades are doing can be equally guided by one’s biases as picking investment opportunities.

Behavioral Finance theory goes against the grain. Instead of stating the seriousness of using mathematical models to analyze financial markets, it points out that the irrationality of investors causes biases in the investing process.

Going to a well-researched Nepali 2014 thesis paper that implemented SmartPLS software for Confirmatory Factor Analysis of hypothesis testing, construct, and model fit, overconfidence bias has the top negative influence on investment performance.

The self-control and regret aversion biases followed it in terms of detrimental impact.

Even though most long-term investors have more than suitable financial education and experience, they still fall prey to their sentiments and emotions that cause them to make intuitional errors.

Now, an internal locus of control substantially strengthens the negative relationship between investment performance and loss aversion. Contrastingly, the negative correlation between investment success and overconfidence gets significantly attenuated by the presence of a locus of control.

But, a significant moderation effect between investment performance and emotional biases did not get attenuated.

Without question, greater self-awareness of how investors feeling affect their judgment can help their investment performances, allowing them to manage assets effectively.

Those in behavioral finance should go to great lengths to spot their mistakes made due to emotions guiding the way, understand them, and put in extra effort to avoid repeating them.

Strategies to Overcome Emotional Biases in Investing

Mainly, laypeople believe that fear and greed drive buying decisions when the market tops and selling ones when it bottoms.

The underestimating risk is also one of the principal causes of why so many investors make suboptimal decisions when their emotions go wild. Media hype as well does enough to get everyone riled up in moments of peaks or valleys, creating panic and haste trades.

Everyone needs to understand that investing should always be a rational-based activity. It should never be a practice guided by behavioral impulses of emotional buying/selling.

Thus, the best approach to this operation is data-based diversification and dollar-cost averaging. The first is purchasing multiple securities in different sectors to diminish the emotional response to market volatility.

It is the go-to advice many finance experts give to newbies. The second is a strategy that involves setting parameters and staying the course. In short, it is investing systematically equal sums at regular intervals, regardless of a security’s value.

By frequently purchasing assets in down and up markets, investors are likely to buy fewer shares at higher prices while getting more at lower ones. It removes the impact of emotional biases altogether.

As we have already discussed, emotions are undoubtedly a two-edged sword in decision-making.

On one side, they hold us back. But they can also help us get what we want. They can focus attention but sometimes act as blinders on a racehorse, causing individuals to fixate on an opportunity and ignore risks.

Nevertheless, it is clear that we have to set them aside when we notice that they are not the correct tool for the job.

Recognizing one’s biases is first accepting that everyone has them and that there is no investment decision free of them. Customary, they are more present in a spur of moment actions. To spot them, one must also be aware of their bias-suitable characteristics.

Plus, monitor their behavior/actions. The latter gets best accomplished through a trading journal, like the ones available in share tracking software, where investors can add the causes that led to making distinct trades.

Most veteran traders would advise avoiding making assumptions or relying on gut instinct, setting ground rules for behavior, and always using tried-and-tested metrics while seldom stereotyping.

To Sum Up

The importance of emotional awareness in investing and gauging investment performance cannot get overemphasized.

One’s biases can dramatically distort reality regarding what an investor should do at a specific moment in time with trades and what moves they should perform in the future. The common-sense approaches are to rely on diversification and dollar-cost average as logic-operated tactics that take feelings out of the trading process.

Of course, it is impossible to 100% eliminate emotions from any activity.

That is why everyone should note what has motivated each of their decisions. So they have an overview of a possible pattern regarding their trading practices, one that may uncover the emotional biases holding them back.

Identifying them is the initial step in removing them and leaning more on logic-powered moves.