Updated: May 9, 2022
Is an overly confident investor most likely to make reckless decisions that could reduce their returns on investment? Investors may unwittingly put themselves in danger if their zeal exceeds their expertise.
As human beings, one of our most valuable assets is our ability to host a variety of feelings and emotions. However, when emotions take over, all rational thought fades away, and the investor can make entirely irrational financial judgments. If left untempered, such sentiments have the potential to wreak havoc on our financial strategy. Let's dive into how a lack of emotional restraint becomes an investor's greatest disadvantage and can ultimately sabotage their decision-making functions when it comes to investments.
Worry and Fear
This is a psychological response in which people with the potential to invest are crippled by the thought of losing that they refuse to take any risk, no matter how insignificant the loss may be on the grand scale. Their apprehension of possibly losing outweighs any satisfaction to be gained from enhancing their wealth. They convince themselves that it is perfectly acceptable to allow their money to remain idle.
No risk, no reward. You can never grow your money if you are too afraid. Inflation guarantees that your money will lose value over time, rather than making attractive returns through calculated risk.
With that being said, there are numerous venture capitalists who – often due to reacting to the markets with avarice or panic – have made losses in the past and choose to refrain from future investments altogether. These people epitomize the phrase “once bitten; twice shy”. They avoid and deny themselves any future investment opportunities, which is a direct sacrifice of making any significant returns by not investing their idle money at all, simply because they are in fear of being deceived again by the market.
Just because you've lost money in the past due to prior erroneous decisions, it doesn't guarantee you'll continue to make those mistakes. In fact, quite the opposite is true, if you are to use those experiences to plan strategically, you can make well-informed judgments that grow your wealth.
This emotion typically occurs when the market is in a downturn. When markets begin to collapse, people become agitated and anxious. This leads to “panic selling”, i.e. when shareholders sell before assessing the bigger picture because they fear their hard-earned money will be lost. Their only aim is to protect as much of their capital as possible by cashing out before the market goes much lower. In their panic, they overlook the fact that the market goes through many cycles. Even if it is currently experiencing a downturn, it can eventually recover and resume its upward trend.
You will turn paper losses into actual losses if you misjudge the upswing.
Avarice or Greed
In a bull market, this familiar yet deadly sensation develops. Over-zealous investors spot an opportunity and become ambitious when they notice positive movement in the stock market. They begin to pump increasingly more cash into the stock market in the hopes of taking advantage of bigger returns and swiftly increasing their fortune. This type of investor is more concerned about missing out on a great chance than they are about taking a huge loss.
Returns and risk are inextricably linked. Higher returns imply a higher level of risk. If you invest when the market is at its highest, you run the risk of losing money during a market correction.
Confidence is defined as the feeling or belief that one can have in someone or something. A positive discrepancy between rated self-belief and observable success is what overconfidence is tips the balance into overconfidence. It can occur as a result of unfounded trust, lack of knowledge, or a hybrid of the two. The overconfidence among us has a tendency to exaggerate their estimations, resulting in an overvaluation of efficiency, and an underestimation of danger.
Overconfidence can be deemed an overly favourable self-evaluation or the illusion of control. As a result, the illusion of control leads to a higher expectation of success than the objective probability would suggest. Due to this reason, overconfident people are inclined to see events as manageable. Investor optimism and overconfidence are bolstered by confirmation bias, in which people seek out information that confirms their prior ideas rather than information that contradicts them.
These are just a few examples of what may happen when emotions collide with investment intentions. Investors experience a variety of emotions throughout the market cycle, ranging from overconfidence and exhilaration in a bull market to despair and melancholy in a down market.
However, there are several techniques you may use to keep your emotions in check while still achieving your financial objectives.
Make a financial strategy in writing
Having a well-defined plan can be more beneficial than retaining all of your strategies in your brain. You should have a well-documented financial plan in place that explains the “why” and “what” behind your investment strategy. You can use such a plan as a reference guide before making any financial decisions once it is in place. So, if you're panicking because the market is plunging, check your strategy to see if you included "Panic
Selling" as a viable option for your investment. (Hopefully, this is not the case!)
Stop obsessing over your portfolio all the time
When you hear any news about the market rising or falling, resist the impulse to check your portfolio. This will simply tempt you to act impulsively and not necessarily in the way you wanted to when creating your strategy. The main reason why investors don't get decent returns despite their well thought out, long-term objectives is that they are constantly examining their portfolios for adjustments on a regular basis. This mindset transforms them from long-term investors to short-term traders. Check your portfolio once or twice a year to make sure everything is going according to plan. If you do it too much, your horizon will be narrowed from long-term to short-term. Investments are similar to acorn trees in that they require time to generate fruit.
Consult a financial advisor
It is always a good idea to engage a qualified financial advisor to aid you if you struggle to hold your emotions at bay when it comes to your money. An advisor can assist you in making the best decisions by providing third-party objectivity and insight. Just remember, your advisor should have all of the necessary credentials and be looking out for your best interests. Much like a doctor, a good financial consultant can keep your money healthy if you offer them the right information and refrain from hiding any truths.
Following these simple steps can result in providing you with a basic and straightforward investment strategy. When sentiments enter the scene does it become complicated and challenging? However, this does not rule out the use of emotions in your investment strategy. Before you decide where you want to put your money, consider your feelings. After all, your degree of comfort is just as crucial as your ability to generate more money. If you're having trouble sleeping because your portfolio is too dangerous, you may want to consider adjusting it and finding the right balance of risk and return in your portfolio, to help you get some rest.
In terms of investment, we hope to have illustrated the direct correlation that misplaced, emotion-led decisions can have in heightening the risk involved in concentrated investment techniques. Overconfident people are more inclined to be frightfully optimistic about their own results and general industry outcomes. They are more likely to trust markets, less likely to seek advice from a consultant. Such overconfidence and faith may assist in understanding the patterns of investors and their investment returns. An insight into these patterns is especially important for financial advisers, who play an essential role in providing feedback and participating in decision-making.
How do you stay in control of your emotions while investing? Please tell us in the comments below.
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