Any investor worth her salt knows that emotions don’t belong in investing. They cloud your judgement, make you impulsive, and cause you to act irrationally.
To make money in the markets, you need to be cool-headed and logical - right? So why is it so hard to keep emotions out of the equation? The reality is that tens of thousands of years of evolution have hard wired us for emotion. Fear saved our ancestor’s lives when they faced dangerous situations. Short life expectancies and constant threats to survival meant that short-term goals received more attention out of necessity. In the same vein, pleasure, like enjoying tasty food, was also a survival mechanism.
The dangerous side of emotions
While emotions have served us well to ensure our survival, they can sometimes get in the way of making good decisions, particularly when it comes to investing.
At the extreme level, investors can become compulsive traders who take large amounts of risk relative to their potential payoffs. What is alarming is the similarity of this type of behaviour to other behavioral addictions such as gambling. In general, the reward processes in the brain that underlie behavioural addictions are similar to those that occur in the brains of chemically addicted individuals.
Although there is no such thing as investing addiction, trading - particularly if done on a daily basis - can likely trigger the same reward mechanisms in the brain that gamblers experience in the casino or in an online game of poker, causing them to take bigger and bigger risks for marginal increases in return. This diminished state of self-control can quickly spiral into insurmountable market losses.
While most investors will never reach this level of compulsivity, it goes without saying that similar self-control issues can arise in all of us when it comes to investment decision-making. Self-control is a limited resource that gets depleted the more we have to use it. As it relates to investing, self-control becomes more depleted the more decisions we have to make. Once its limits are reached, we are likely to make poor choices.
A simple way to avoid hitting your limits of self-control when making investment decisions is to develop a detailed investment plan. Building an investment plan is effectively a journey in self-discovery. You need to get acquainted with the levels of risk you are comfortable dealing with. This includes taking a hard look at how much you’re willing to lose on your portfolio when you realize you’ve made a bad decision (bad decisions are inevitable, by the way). It also entails setting trading guidelines. These guidelines will depend on the frequency with which you trade. If you’re an active trader, your guideline will likely be more in-depth than if you’re more of a passive, buy-and-hold investor. You can also automate parts of your plan and systematize other parts of it.
Minimize the impact
While it is impossible to eliminate emotions from your decision-making processes, there are ways to minimize their impact. It is a good thing that we are not robots, because being emotionless doesn’t necessarily make us better decision-makers. It therefore becomes important to understand how emotions influence our decisions, and in what ways they can be managed to minimize investment risk and losses.