Risk and Emotions

Investing is difficult, very difficult in fact! Being human actually makes it harder still. Why you may ask? Well, it is because even the cleverest individuals are affected by cognitive biases which are driven by our personal life experiences and memories.

Consequently, we all react differently to events and that is just human nature. When it comes to investing, typically this will impact what you do with your spare money, do you save it, do you invest it or do you hide it all under the mattress? Inevitably, it will also affect how you react to stock market volatility, whether it be fear and anxiety to losses, or confidence and elation to gains. Some will see markets fall and immediately panic and extract cash, others will take a sensible long-term view and allow heightened volatility to subside and then there will be those that take the opportunity to invest more. On reflection, despite the volatility that stock markets have endured over the past century, as a result of world wars, depressions, recessions, financial crisis and international upsets, stock markets have remained extremely resilient, delivering generally wonderful results to patient investors over the years.

Of course, it is investors’ reactions to events which makes markets and creates opportunities with a combination of buyers and sellers. When markets learn of potentially bad news, sellers often over-react and dominate (driving down prices) whereas more favourable news is when buyers may increase activity (pushing up prices, sometimes excessively). So, what you may say, you know all of that. Yes, you may do, but the key is to understand how your cognitive biases affect your investment decision making as this may save you from potentially expensive and disastrous mistakes.

As investors, we need to harness this and recognise how the masses react and whether that reaction is justified. The “bandwagon effect” or herd mentality is something that people do purely because others are, regardless of their own beliefs. By understanding this in an investment environment and perhaps acting contrary to the masses will allow us to benefit from the overreaction to such an event perhaps – suggesting that a bad situation can be over-played and positive news taken too complacently.

Whilst it is easy to say and difficult to apply, as investors we must do our very best to disregard the short-term “noise” and sometimes our natural human tendencies and remember our original longer-term reasoning for investing in the first place.