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Investing can be frustrating, can’t it? You can read a hundred articles and a dozen books on investing; for some reason, your investment returns still refuse to improve. To make matters worse, sometimes an ordinary Joe with no background in finance will come along and outperform you! In fact, they may, for a while, even outperform experts in the field. Why might that be?
Well, unlike other fields of expertise, you can argue that education, experience, resources and connections, while still vitally important, come secondary. The most important factor in investing is psychology and behaviour, which is why the topic of behavioural finance even exists! You can have all the knowledge in the world, but if you’re not aware of and in control of your investing psychology, you will be prone to biases, emotional decisions or irrational assumptions.
As an investor, you will need to understand and recognise the emotional rollercoasters you go through when trading in the financial markets. Only then will you be able to control those emotions to maintain a logical state of mind and make optimal investment decisions for your portfolio. Fear, greed and ego (or pride) are three of the most controlling emotions that investors usually face. Let’s take a look at them!
The fear of potential losses is something all investors have in common. After all, who would want to lose their hard-earned money? We’re not saying that any amount of fear is bad; it’s good to have a sense of risk-aversion, but too much risk-aversion is a problem because it will limit your potential upside. As we all know by now, investment products with high potential upside will always come with high risk. It’s best to find a healthy level of risk-aversion that suits your financial goals and your current financial situation!
Another scenario where fear may control you is one that every investor will be familiar with, and that is when our open positions are loss-making. We get it. Seeing those red digits on your trading platform will set off alarm bells in your head. Whether it’s stress, frustration, or panic that initially overwhelms you, remember to take a step back and clear your head before doing anything. Do your research to understand why the market is not responding or moving as expected, and then make your decision.
One simple way to think about it (unless you're in a country with capital gains taxes where you can "harvest a tax-loss") is that holding onto your shares at the current price is the same decision as choosing to buy them at the current price, regardless of where you originally bought them. This also applies regardless of the price yesterday or whenever you last thought about selling/buying more of those shares. Simple idea, but very difficult in practice!
Similarly, if you want to buy something that you don't have the cash for, do you sell shares that you made money on, or sell out of something else that you lost money on? What if you have to put more money in because you had a margin call on a stock that has just recently collapsed, and you don't want to get "force sold"? Psychology, amirite?
When you’re trading on margin (borrowed money from your broker), a margin account is opened for your initial investment. This account acts as collateral for your open position and ensures that you never owe the broker any money, meaning you and the broker can rest easily.
If your position is loss-making, your losses are immediately taken out of this margin account. When your margin account hits a minimum threshold, called the Maintenance Margin Requirement (MMR), a margin call will take place to request that you top up your margin account.
If you do not top it up, you will have your position forcibly closed by the broker to prevent any further losses (and hence an owing of money). Some brokers do not perform Margin Calls and will instead close your account immediately once it hits the MMR. In this case, the requirement level may be called the Margin Closeout.
Greed is rather straightforward. It’s about chasing after higher and higher returns. Sometimes, investors hold their positions open for too long, and when the market reverses, they lose everything they had made. Prudence is the key when deciding when to close a position (whether at a gain or a loss). Selling too early when the stock or market is rallying hard and in a bull market is also a nightmare! Do you buy back at a higher price after you "sold too early"? What if you sold at a loss and then the stock rallied? If a share's price keeps increasing, do you buy more shares of a winning position at higher prices, or do you start selling bit by bit once the position becomes too big relative to your other holdings? And if so, would you then put the money into the shares that have sucked?
The answer to all the above is: "Maybe." You're welcome.
Greed is also about biting off more than you can chew; don’t take on a level of risk that you aren’t prepared to deal with when things go wrong. Prepare yourself by having enough knowledge of the shortlisted shares / financial instruments, having sufficient capital and being in a proper emotional state before making risky purchases (including buying on leverage or using derivatives).
Ego is a particularly nasty one and is especially relevant for male investors. Warwick Business School’s June 2018 analysis of 2,800 independent investors reflected that the women outperformed men by 1.8% in annual returns. That may not sound like a huge amount, but that's 20% outperformance after only ten years and over 50% after 25! The need to “one-up” fellow traders and be the best may lead to rash and unjustifiable decisions.
Investing isn’t a competition against your peers; it’s about achieving better returns than other readily available alternatives (e.g. bank accounts or a unit trust from a fund manager you've vaguely heard of). Don’t worry too much about what others are doing. You may want to go to them for advice, which you absolutely do not have to act on (even at the risk of the dreaded "I told you so" from them!), but you should always quell that competitive side of you that envy or frustration can control.
An inflated ego because of past or recent successes may easily lead to overconfidence. You're an investing god. Really? Really?? It’s important to always base your investment decisions on facts and all available information and not just your gut feeling or instinct. Sure, with more experience, a lot of your "gut instinct" may come from the information available and the patterns you subconsciously notice, but it doesn’t hurt to double-check before you decide. This gut instinct is never 100% reliable, and for many people, even professional investors, this may never move much out of the 50-50 range, i.e. totally useless!
INVESTOR PSYCHOLOGY. COMPLETED. ✅
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