Whilst it’s true that modern psychology is founded on the assumption that, in general, humans tend to think and behave rationally, this assumption has become somewhat of a misnomer in the realm of investing. Enter the relatively new field of behavioural finance where psychologists and behavioural specialists are still trying to fathom why, in the face of clear logic and indisputable facts, investors are driven to abandon their clearly-mapped financial plans and prejudice their financial futures by their irrational, emotionally-fuelled behaviour. And of all the emotions that investors are confronted with on a daily basis, it’s greed and fear that are most likely to take the blame for wealth destruction.
Although the human species is hard-wired with a series of in-built emotions that are designed to ensure our ongoing survival, it is curiously ironic that our innate emotions of greed and fear, when given free reign in the investment markets, can serve to work against our primal survival instincts to so greatly prejudice our financial futures. At the top end of the investment market, greed drives investors to purchase stocks in insatiable quantities, whilst at the bottom of the market, irrational fear moves investors to shed their stocks quicker than you can say ‘low-risk investments for me, please’. And while endless volumes of research, statistics, graphs and guides reiterate what everyone already knows – that investors are notoriously bad at timing the markets – many investors continue to bow to the emotional pressure of overriding greed and irrational fear to their very own detriment. How is it that rational, thinking and educated people can make such irrational, uneducated and inexplicable investment mistakes?
Greed, in the context of investing, is defined as an excessive desire to create as much wealth as possible over the shortest possible period of time – and it’s this ‘get rich quick’ mentality that makes it difficult for investors to maintain their gains and stick to a strict investment plan. Any financial planner who’s worth their weight in gold will advise any client to maintain a long-term investment horizon when it comes to funding for retirement, and to stick to his game plan regardless of inevitable short-term market volatility. As advisors to many retirement funding clients, our advice is (and has always been) to paint ones retirement lifestyle and then develop an investment plan geared towards achieving these goals. Remaining intently focused on ones retirement goals will reduce the possibility of being side-swiped by the latest stock craze or get-rich-quick scheme. Sticking to ones longer-term investment plan in the face of personal feelings of greed or fear will result in inevitable investment success. You definitely won’t get rich quickly, but you will create genuine, sustainable wealth.
Fear, being an intense feeling of awareness of danger or loss, can wreak havoc in the stock markets as investors bid to stem their losses by moving out of equity markets into lower risk investments. As share prices drop, investors tend to behave as a frenzied flock as they flog their shares and buy into lower-risk, lower-reward money market investments – with absolutely no regard for their long-term investment plans.
To exacerbate the problem, fear itself is further fuelled by what is known as loss aversion – the fear of losing something that one already owns. Psychologists believe that our fear of losing something is greatly outweighed by our desire to gain more. Into the fray is thrown the fear of regret, which is the fear that investors feel when they think they’re missing out on a once-off investment opportunity, a get-rich-quick tip-off or a sure-thing investment. Through fear of missing out, investors are driven to behave with a herd-like mentality whilst their behaviour flies in the face of all logical explanation.
The reality is that, whether an investor’s behaviour is driven by fear or greed, scrapping ones long-term investment plan for the latest stock craze can damage ones financial plan just as much as irrationally switching ones investments to a lower-risk, lower-reward portfolio out of fear. Behaviour driven by either of these emotions generally results in nothing but a worthless financial plan, an irate financial planner and an embittered investor.
After thirty years of research we now understand considerably more about investor behaviour than ever before, although there is still much to be uncovered. In the emerging field of neuro-economics, recent studies reveal that investors are not only influenced by their emotions, but by the time of day, the weather, their attire and hunger. It’s been proven that a woman’s hormonal cycle can influence her tolerance for risk, whilst men with higher testosterone levels have a greater propensity for risk than their lesser-fuelled peers. When taking investment decisions with their fellow investors, people tend to take riskier decisions than when on their own, and people who’ve just made a lot of money will be less cautious when it comes to risk-taking in general.
Investment markets are, by their very nature, riddled with the volatility of peaks and troughs, the unpredictability of booms and crashes, and the inexplicable reality of market highs and lows. Accepting that the investment graph will rise and fall many times over one’s long-term investment horizon is the first step towards adhering to a well-constructed investment plan. As difficult as it may appear, the answer lies in the ability to de-sensitise oneself to the inevitability of market fluctuations and ensure that one remains invested to achieve a pre-determined set of retirement goals. The peaks and troughs that occur in-between are nothing more than peripheral investment noise and shouldn’t impact one’s investment strategy in the longer term. Successful investing towards long-term and sustainable wealth is about remaining focused on one’s financial plan, unaffected by market noise and vigilant against the ever-destructive nature of greed.
Have a wonderful weekend!
Categories: Financial Planning