influence your investment decisions more than the numbers on the page of an investment prospectus or financial report.
Cognitive dissonance - the feeling of discomfort we have when faced with holding two or more conflicting thoughts, beliefs or emotions.
One of the most powerful behavioral finance concepts is that of loss aversion; the tendency for people to strongly prefer avoiding losses than acquiring gains. Studies have shown that individuals feel more pain from losing money than satisfaction from gaining the same amount of money. In simple terms, cognitive dissonance occurs when we are happy about the possibility of making a fantastic return but also fear the loss of any of our capital if something goes wrong. Sometimes called “buyer’s remorse”, this discomfort will keep many an investor from making higher returns. What can we do to overcome this pitfall?
The first key is to get some help. A Certified Financial Planner or a full service stock broker can help you with the research necessary to identify and minimize the risks that may give you sleepless nights. Even the Oracle of Omaha, Warren Buffett, relies on the input of advisors to make investment decisions. In the investment process, the financial planner will help you look at various scenarios and establish the level of risk you are truly comfortable with. Drawing on years of experience in investment analysis, a good adviser will explain how each investment works relative to your goals and objectives and help you select the right ones.
GOALS & OBJECTIVES
The second step is to identify what the investment is to accomplish. Is this a short term investment with the funds required within the next twelve months? Can the investment be mid-term and remain untouched for the next 2-3 years, or can it be left for 7-10 years or longer? Investing usually has a purpose and it’s important to convey your goals to your advisor so you can jointly decide on the investments that work towards that purpose.
This is very simple to state but most investors have a hard time with it. The longer the investment horizon, the greater the chance an investor will lose patience and cash out. Investors need to look at this horizon like flying on an airplane from one point to another. On a flight the pilots are in control; no matter how much turbulence the plane is subjected to, the only sane option is to “grin and bear it” until the plane lands at its destination. Investing can sometimes be similar, subject to turbulence; markets go up and down and investor patience is seriously tested. Emotions can run from optimism and excitement, to anxiety, fear, and panic – and later to despondency or depression in a relatively short period of time. At this stage, the support of a trusted advisor is key. It is important for the investor to revisit the goals and objectives and the reasons why the investment was selected and started.
ENTRANCE & EXIT
If you are a speculative investor, accustomed to investing in high risk investments like individual stocks, you must establish an investment process of when to get in and out of each investment. For example, if your investment appreciates or depreciates by 25% you sell and move on regardless of what your emotions tell you. Buy low sell high, an expression most investors have heard, is actually sound financial advice. Unfortunately, when fear (emotion) takes over, people find themselves doing the opposite; buying high when the market is appreciating to get in on the rumored great returns.
Recency bias or the tendency to think that trends and patterns we observe in the recent past will continue in the future.
When the markets take a downturn turn some investors panic and sell at a loss, now victims of this type of cognitive bias. If you are a simple, risk adverse investor, then work with your planner to find investments that resonate with your objectives and set your entrance and exit points.
Knowledge is power. It gives us the power to make informed decisions. However, too much knowledge and an investor can become confused. We get information from the TV, news reports, and business reports. We get information from financial institutions and from our friends and family. Everyone has heard the story of a person who invested $10,000 in a small penny stock and went on to make hundreds of thousands, even millions of dollars, when the stock took off. Investors dream of this kind of magic however, this is where specific knowledge comes in to quell the greed factor.
The reality is that those ‘true’ stories account for less than 1% of investors. The higher the risk the greater the return but there is also the greater possibility of a loss. With the help of a financial planner you can distill all the information into knowledge that is specific to your goals and objectives, and keep the greed factor minimized to allow for more realistic expectations of returns. Investments come in many forms: term deposits, RRSPs, stocks, bonds, real estate, and even buying a business.
The typical non-professional investor puts his/her hard-earned cash at stake and, while hoping for a gain, wants to protect that cash against losses. Investors get investment information from many sources such as mainstream media, financial news, friends, family, and co-workers. The investment experience for some can be an emotional rollercoaster, plummeting from excitement and optimism to the lows of despondency and depression.
There are some simple keys to minimize the cognitive dissonance that most people experience investing their money. The first is to leverage resources and hire a trusted advisor, preferably a Certified Financial Planner, to help you navigate through the turbulence associated with some investments. Second, set proper goals and objectives within your investment process that will define the investments you pick. Third, have patience and stop worrying about the turbulent ups and downs. You have no control of the market fluctuations. Fourth, work with your planner to decide when to get into the investment and when to exit. And fifth, focus on the specific information that is relative to you. This is the knowledge that gives you the power to understand the what, when, how, and why of your particular investments. Do these things and you will not only reap the rewards, you will have greater peace of mind.
Make more money on investments and achieve greater peace of mind
Every investor will eventually place their money into an investment, looking for the greatest returns with the least amount of risk to their capital. No one wants to lose money. You may believe that you are a rational investor however research from the field of behavioral investment suggests that your emotions, your drive to emulate the actions of others, and your general aversion to loss,