Emotions and Their Impact on Investor Behaviour

Emotions have always influenced people’s behaviour in their daily decisions. Emotions were ingrained in people long before rational behaviour arose, which is why the manifestations of emotions are usually stronger and sometimes difficult to control.

Emotions directly affect almost all aspects of human life – be it interpersonal relationships, work relationships, daily decision-making processes or even investment decisions.

When it comes to investing, emotions are a frequent source of bad investment decisions. For example, emotional behaviour under the influence of the FOMO effect (fear of missing out) can push investors to buy assets during rapid growth at the peak of a market cycle. On the other hand, fear and uncertainty about future developments influence behaviour during downturns, so investors often sell their assets during downturns and at a loss. However, neither of these two examples has anything to do with rational investing, which is the basis of success.

Although traditional financial theory predicts that all investors in the market behave rationally to maximise their profit, it is clear from practice that this is far from the truth. Investment practice shows us that many investors in the market do precisely the opposite – they usually behave irrationally and emotionally, which often causes bad investment decisions and the loss of their capital.

Behavioural economics, which examines the impact of social, emotional or cognitive factors on the economic decision-making of individuals, says that investors are not nearly as risk-averse as they are loss averse. This means that people experience and feel the emotional pain of losing funds much stronger than the joy of making a profit of the same amount.

Therefore, if the investor is at a loss from their investment, they feel much more pain from losing their funds. This pain often forces them at some point to sell their remaining assets and cover at least some of their losses. However, it is not rational to sell assets at a loss because markets have a long-term upward trend. If an investor sells at a loss, they not only lose their invested capital and future profits forever but are also demotivated to reinvest in the future.

Much could be written about the impact of emotions on investments. Under the influence of emotions and social networks, investors often make trades that they would never do under standard conditions with rational thinking. Therefore, learning to separate your emotions from investment decisions is very important.

Market Cycles and the Impact of Emotions 

Financial markets, whether stock, commodity or cryptocurrency, never rise in a straight line. Corrections have been part of all markets for decades, causing capital outflows and asset value declines. Individual phases of development and the behaviour of investors in the markets are characterised by market cycles.

Market cycles are very important to investors. They can tell investors how to behave during various market situations, when to invest aggressively and, conversely, when to reduce or completely close their trading strategies.

The popular American investor Howard Marks in his book “Mastering the Market Cycle,” lists three basic phases of the bull market cycle: 

• Phase 1, when only a minimum of people believe that the market situation will improve – the market bottom 
• Phase 2, when most people believe that the situation will improve – market growth 
• Phase 3, when everyone believes that the bull market will stay here forever – the top of the market
  

While some of you may be thinking, “I’m definitely in phase 1,” most regular investors enter the market right in the third and final phase of a bull market – right when asset prices are attacking their all-time highs, and market euphoria is enormously positive. However, usually after the completion of the third phase, there is a crash and transition into a bear market.

A great illustration of phase 1 from practice is the financial crisis at the turn of 2007 to 2008, when investors withdrew money from the market during the crisis and cash flows into mutual funds were negative. During these outflows of capital from the market, it turned out that the net outflows were highest precisely when the market was at its bottom – that means that the vast majority of investors sold their assets under the influence of emotion at a loss at the worst possible time.

Many of the entities that sold their assets at the market bottom returned to the market after some time – but on the opposite side of the market cycle, precisely in phase 3, when asset prices were reaching new price highs.

This situation perfectly illustrates that the most crucial factor in successful investing is patience. Speculation and emotional decision-making often do not pay off in the short term.

How to Get Into Emotional Stability When Investing?

In practice, there are several ways to eliminate the influence of emotions on your investment decisions. These include, for example:

• Diversifying your investments – Diversification is a technique by which investors reduce the risk in their portfolio. By spreading the investment between multiple assets, the representation, as well as the risk of each asset, is reduced. Investors who diversify are usually more comfortable than investors who take risks and invest only in individual assets.
  

• Invest regularly – Investing regularly is perhaps the best tool to average your initial investment. By investing regularly, the investor can eliminate the possibility of a bad purchase (for example, buying at the market peak) and can thus handle price drops on the market much more easily. Many investors use price dips to average their investments and expand their portfolios.
  

• Don’t check your portfolio 20 times a day – Checking the status of your portfolio 20 times a day will make absolutely no difference. Constantly checking the status of your investment can cause you more worry and stress than benefit. Check your portfolio at reasonable intervals with a cool head and use price dips to improve your investment position.
  

• Have a clearly defined investment strategy – It is very important for the investor to know the time when they want to exit the market. Selling assets at a loss does not make sense, but holding them indefinitely isn’t a solution either. Set your exit strategy, and realise your profits according to your strategy. Never change or modify the strategy because of your greed; it can easily rob you of your profits.
  

• Only invest money you can afford to lose: Never invest funds whose loss could somehow affect your standard of living or your housing. Invest so that you can cover your current expenses while saving for your future.
  

• Choose proven assets – Avoid investing in speculative coins and tokens with low market capitalisation due to their possible high growth. Investing in new and unknown tokens without technological potential usually ends very badly.If you can’t make up your mind, put your decision in the hands of the experts.