Human beings are emotional. Sure, we all know this. However, when it comes to investing, it appears we don't always understand (or acknowledge) the stress that investing can place on our emotions and how these can influence our decisions on when buying and selling ASX shares.
So, what are these emotions and how can we deal with them?
I think one of the best ways to deal with your emotions is to start by understanding them. Emotional biases can hurt portfolio returns, so once we have understood what they are and where they come from, we might just have a hope at finding a way to help avoid or reduce their effects.
So, lets focus on a couple of the more common emotional biases. If they sound familiar to you, don't worry, you are far from alone!
Loss-aversion bias
You have probably heard of loss-aversion bias before, and roughly speaking it is the effect of feeling greater pain from a loss than that of an equal gain. This would often lead to investors holding onto declining shares – hoping to break even in the future and selling winners too quickly for small profits. Consequently, this also leads to an increase in trading and transaction costs.
It is important for people prone to loss aversion bias to recognise the above traits and remind yourself that it is not the initial entry point into the stock that you should frame your gain/loss from but in the quality of the business over time. Updating your view on the company through analysis and fundamentals instead of share price movement can help alleviate the impact of this bias.
Regret-aversion bias
Regret aversion occurs when people avoid making decisions due to the fear that they will make a wrong or bad decision. This excess fear will often lead them to stall or stagnate, as they prefer to do nothing to avoid being wrong.
This bias can be common in new investors, as they fear buying shares and don't want to make the wrong decisions, and with so many stocks and opinions out there it can be easy to see why. Conversely, current investors can also suffer from this bias by holding onto shares for too long and not selling out of fear the shares will increase in value.
Luckily, the more you understand something, often the more comfortable you are with it. Here, education is the key to overcoming regret aversion. An understanding of diversification and the decision-making process behind an investment can help new investors enter the market. For me, by keeping track of the investment philosophy under which I bought the shares, it's easier for me to see when an investment no longer aligns itself with these views and recognise that it may be time to sell.
Overconfidence bias
When markets trend up, it can be easy to overestimate the success of your investing decisions. Similarly, some intelligent people may believe they should be better at investing on the basis of their general intelligence, despite no education in the field. These 2 examples may lead investors to understate risks and overstate returns.
Being honest with yourself can help in overcoming overconfidence bias along with conducting an analysis of past portfolio performance. Due to hindsight bias, we tend to recall winners more than losers and by evaluating past performance we can accurately measure our abilities.
Foolish takeaway
Emotional biases can lead to excessive risk taking, un-diversified portfolios, excessive trading costs, selling winners early and holding onto poor performing stocks. All of these things can really hurt portfolio returns, especially in the long run when you consider the effects of compounding returns.
However, by building yourself a little check sheet and reviewing it once every 6 or 12 months, I believe you can evaluate your own investing biases and performance from an neutral perspective and allow you to put to use some of these preventative measures.
