Warren Buffett once said that “while reasonable intelligence is essential to be a successful investor, temperament is key.” The essence of the words from one of the most successful investors ever is, if you cannot control your emotions, you cannot control your money. Let us explore this further.
You might worry about how markets will perform, the taxes you pay or the financial advice fees you incur, but in fact our emotions are the biggest driver of our investment decisions, and the returns we experience.
Staying calm through the ups and downs
Humans have a natural tendency to focus on the short-term, which can lead to making decisions that are counterproductive to our long-term goals. This fixation is exacerbated when such short-term events are extreme or negative in nature such as a global pandemic, a war, an energy crisis, record levels of inflation, the list goes on.
It would be normal for anyone to feel worried, nervous, or scared about their money during times like these. When we start to feel these strong negative emotions, our fight or flight instinct is to take immediate action to feel some sense of comfort again.
An example of this would be selling investments at or near the bottom of the market for fear of further losses and seeking refuge in the safety of cash. If not exposing ourselves to the emotional rollercoaster of stock market ups and downs means investing in cash, you will lose purchasing power to inflation if held for long periods of time, which does not make sense for the long-term investor.
Once out of the market, it is often extremely hard to get back in due to the stress and pain you have already experienced. A common occurrence is to invest once ‘normality’ resumes, and markets are buoyant again. By this point the investor has missed the bounce back and foregone often substantial gains.
This kind of behaviour can be explained by some well documented psychological theories (or emojis in this case). Let us focus on two of these:
Herding is our instinct to follow what others are doing, in the belief that they know more about a given subject than us. It happens in all areas of life, including investing. This is why we are so influenced by the headlines we see in the financial press as they are written by what we believe to be ‘experts’. The trouble is that most headlines talk intentionally of perilous doom & gloom, sensationalised by news outlets. SPOILER ALERT: bad news will always sell more newspapers than good news.
Loss Aversion is the theory that the fear of being wrong and taking risks outweighs our fear of missing out. Therefore, many people choose not to invest money when times are bad, despite this usually being the best time to do so! We are purchasing short-term emotional comfort at the cost of long-term returns.
Taking a long-term view
Award-winning investment psychologist Morgan Housel said that “An underpinning of psychology is that people are poor forecasters of their future selves.” This is especially true when they are in a stressful situation. Making poor decisions i.e., jumping in and out of markets in the short-term, is a sure way to derail you from your long-term financial goals. Carbon’s role is to provide long-term perspective to keep our clients on track, and not let markets lead them astray.
We build robust financial plans and continually review these with our clients. By having a clear plan, you are much more likely to stick to it. One bad year of investment returns should not materially impact a 20+ year plan.
We provide ongoing investment coaching, so you understand why markets behave the way they do. By experiencing and knowing what to do during bad years, this allows you to better deal with future market falls. On average we experience a market crash every seven years, so it is more than likely you will see some more!
Using a cost-effective evidence-based investment solution stacks the odds in our clients’ favour. Accepting that it is impossible to tell which companies will do well and when, you are much more likely to be a successful investor by holding a globally diversified portfolio for as long a period as possible.
Should you wish to discuss any of this article in further detail, please do not hesitate to contact George Sampson by email or speak to your usual planner at Carbon.
The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.
This communication is for general information only and is not intended to be individual advice. It represents our understanding of law and HM Revenue & Customs practice. You are recommended to seek competent professional advice before taking any action.
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