Behavioural finance: how your mind affects your investments

Your emotions could be having a big impact on your investment decisions

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Invest with your head and not with your heart is an oft repeated phrase but it's easier said than done, even for the professionals.

Investors should not underestimate just how large a part their emotions play when it comes to money; from having the willpower to save to holding your nerve when stock markets are rough, all of your decisions will be affected by your emotions to some extent.

Mark Fenton-O'Creevy, professor of organisational psychology at The Open University Business School, is an expert on investor behaviour and said emotions cloud even the best of intentions.

He believes that emotions can push investors off course, this includes the age-old dilemma of buying at the top of the market and selling at the bottom as fear of missing out, and fear of losing money take over as markets rise and fall.

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He uses a US study into how savers invested the workplace pensions, known as a 401k, to demonstrate the ill effects. The study revealed that people invested with their hearts rather than their heads when stock markets got rocky and that they consistently underperformed the market because by bouncing in and out of their investments, they invariably mis-timed it.

Fenton-O'Creevy said the assets consistently underperformed by 4%.

Maike Currie, associate investment director at Fidelity Personal Investing, said that investors could lose out if they succumb to nerves.

"Investing should ultimately be a long-term game and investors should not be put off by short-term market jitters," she said. "An investor who remained fully invested from 1994 would have earned a total return of more than 300%. One who missed just the 10 best days in the market would have reduced their return by two-thirds to just over 100%."

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Fenton-O'Creevy is part of a course to teach financial traders how to regulate their emotions, but some of the findings could be used by private investors to help them better understand their emotions and even to use their emotions to their advantage when investing.

In his research into this issue – including interviewing traders and monitoring their heart rates - he found that those who were able to regulate their emotions were better traders.

Regulating emotions should not be confused with having no emotions; instead it means not suppressing them or being overwhelmed by them but understanding them and being able to handle them.

Fenton-O'Creevy's report stated that his study of traders showed "less experienced traders had lower ability to regulate their levels of emotional arousal during stressful trading then more experienced traders"' and the "fact that more experienced traders had learned to regulate their emotions pointed to emotion regulation as a skill that could be trained".

Investors should also be aware of the emotional response they have to loss versus the response to missed gains, which should help identify the right level of investment risk to take.

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Fenton-O'Creevy found that "regret associated with missed gains affects behaviour less strongly then regret associated with losses".

While losses are not pleasant for any investor, professional or otherwise, the research found another common investor experience: that a carefully planned strategy is unable to be implemented because of the intensity of the investor's emotions.

One investor involved in the research said: "I thought it was my dirty little secret how emotional I get about my trading...I execute trades perfectly when I try them out [in simulation with nothing at stake] but as soon as I am trading with serious amount of money it all goes [wrong], I panic and pull out early or freeze and stay in too long and watch it all disappear into a black hole."

This points to the fact that investors need to be disciplined when it comes to strategy, setting out goals and reminding yourself why you are investing and what you hope to achieve.

"Reflection can be informed by structured approaches to writing down and reviewing trading strategies, accompanied by structured reflection about emotional state and management of emotion while making key decisions," said Fenton-O'Creevy.

By regularly reviewing their investment strategy and emotional responses an investor could "highlight when behaviour is inconsistent with planned trading strategy at a period of significant anxiety and provide the opportunity to review how this came about".

Fenton-O'Creevy said that by writing down investments and trades, which is what professionals do, provides a "commitment mechanism" so that investors stick to their guns and don't let their heart take over.

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