How does investor psychology affect the way you invest?
Have you ever bought something on sale that you didn’t really need simply because it was on sale and it was the last item of its kind in the store? Then, you never used that item and it sat around your house until someone got smart and threw it out. You bought that item because it seemed like a great deal at the time. But, in fact, our brains are hardwired to react to a perceived deal, especially when an item appears scarce.
This is a bit of a silly example, but the point is clear: the way your brain works (meaning how you think) has an impact on your investment decisions.
So what are we talking about here?
Behavioural finance studies economics, finance and psychology to understand why people make certain financial decisions. There are many psychological factors that affect the way you invest. Loss aversion and media response are just two of the most common.
Loss aversion1
For some investors, the fear of losing money outweighs the potential to earn money. If this sounds like you, you may be more likely to avoid “higher-risk” investments (i.e., equities) in favour of “lower-risk” solutions like many fixed income investments or cash equivalents.
While it’s true that you’ll probably reduce volatility and financial losses with lower-risk investments, you’re also unlikely to earn enough to keep pace with inflation or to fund a longer retirement. On the other hand, if you can accept that equity investments might lose value from time to time, you’ll benefit from the higher gains equities tend to achieve over the long term.
Media response2
You may have noticed that markets tend to overreact to both good news and bad. XYZ Inc.’s stock plunges because its Chief Executive Officer (CEO) resigns suddenly, even though the company has a solid succession plan and the CEO’s departure had no impact on its financials. Or, ABC Co.’s stock price soars after the company moves into a promising new market, although it’s still very unclear how well the company will perform in that new market.
While it is important to know what’s happening in the world and the financial markets, not every great headline represents the best possible investment idea. We often refer to headlines as “noise.” My job is to help you stay on track by blocking out the noise and encouraging you to maintain investment discipline.
Contact our office today if you have any questions about your financial plan or your portfolio.