Investing in the stock market can be a thrilling activity, and it comes with the potential for great rewards. However, your success as an investor can hinge on your emotions and decisions – on what is called investor behaviour.
Researchers have found strong connections between social, emotional and cognitive factors that affect human investing decisions and the subsequent financial outcomes. In this article, we will dive into the attitudes and behaviours of good and bad investors, share the contrasting impact these behaviours have on portfolio outcomes, and show you how to be a better investor.
- Good investors are patient, disciplined, and diversified
- Bad investors are impatient, emotional, and have no strategy
- Avoid emotional investing and timing the market for financial success
What is Investor Behavior?
As financial advisors, we are super alert to different kinds of investment behaviour! Why? Well, it turns out that research in the field of behavioural finance has shown that people tend to make some pretty irrational investment decisions.
There’s a connection between our emotions and the crazy twists and turns of the market. Moreover, there are different types of investor behaviour out there, which cause people to make specific choices when it comes to their investments. Investor behaviour is based on how we respond to uncertainty, to the different news reports or opinions we hear, or to trends in the market. Each person’s individual comfort with taking risks, and their ability to emotionally handle losses or investment returns, are often the factors that determine our response.
So why is this good or bad? Let’s dig into these different types of investor behaviours and find out.
The Emotions of Investor Behaviour
The psychology behind investor behaviour and investor emotions is fascinating. Just like the ups and downs of the market, our emotions mirror those fluctuations. It’s crucial to grasp how powerful our emotions are in driving our response to situations, particularly financial ones.
As we journey through a market cycle, we will encounter a range of emotions that can affect our actions and therefore, our portfolio.
A study conducted by DALBAR, an independent financial research firm, revealed that the average investor will often perform worse than the overall market.
From 1999 to 2018, the S&P 500 index had an average yearly return of 5.62%, while the average investor only achieved a 1.71% return!
This shocking performance gap can be largely attributed to emotional decision-making and behavioural biases.
DALBAR walks us through the market cycle and our corresponding emotions. During the early stages of investing, investors often experience optimism, excitement, and even euphoria. As the market fluctuates, investor emotions become increasingly positive when returns are high and feelings of euphoria peak.
Then, when the market inevitably experiences a decline and investments lose value, uncertainty can lead to feelings of nervousness and anxiety. Will the market continue to fall or will it recover?
At this stage, investors may start to panic. They become their own worst enemies by losing sight of their long-term investment objectives and selling their stocks hastily to avoid losing even more. This impulsive behaviour results in significant losses for their portfolios when the market rebounds.
When the market rebounds, these investors regain confidence in their long-term investment strategy. However, prolonged volatility or an ongoing downward trend may cause increasing fear of losses and uncertainty about the market’s future.
The DALBAR Study also discovered that many active investors had an average holding period of just over 3 years. Why? Because these changing emotions are misleading, with investors making poor decisions based on fear and loss aversion, or even a belief that they can ‘time the market’. As a result, they may hastily sell their portfolios when their investments are worth the least.
This is why so many Australian investors consistently achieve lower returns than the market average.
So what do you do when you hear bad news? Or when the market declines due to global events beyond your control? The more awareness an individual investor has about their emotional responses, the more able they will be to overcome their cognitive biases and respond rationally to changes in the stock market.
FAQ: Should I sell when the market drops?
It’s important to avoid panic selling when the market experiences a drop.
Instead, staying invested for the long term can be more beneficial for you and your portfolio. Selling hastily during a bear market can lead to much lower returns, and there are several reasons why it’s wiser for investors to hold on to their investments. If your portfolio is well-diversified, you shouldn’t need to panic or worry. However, if you are investing with individual companies, it is wise to periodically review their financial statements to ensure that they continue to be financially stable even during a downturn.