August 9, 2017 / Published 9:00 AM EST / Iris Oberlaender, Staff Writer
3 ways to be smart about your emotions when investing
When you're faced with a decision, do you listen to your gut, weigh a carefully researched list of pros and cons or ask for advice? While some purchases, like that new designer watch you didn't need but treated yourself to, may set you back a few hundred dollars, investment decisions made on emotion alone can have a much bigger impact on your finances.
Men with a high-income are more likely to act on gut feeling or on a friend's recommendation when it comes to investing. In fact, 69.2% of men with an income between C$100,000 and C$149,000 said they regretted making an investment decision based on emotion, or gut instinct.
Why do people make irrational financial decisions? Enter behavioural finance. It's a relatively new science that combines behavioural and cognitive psychological theory with conventional economics and finance to provide some answers.
Researchers over the last three decades have found that overconfident investors are more likely to make frequent trades and higher costs are hurting their returns. Another common scenario is high hope coupled with disproportionate fear which leads investors to buy stocks when prices are up and sell when markets are down.
Meir Statman, the author of Finance for normal people: How investors and markets behave, and finance professor at Santa Clara University's Leavey School of Business, has coined a new concept in behavioural finance that says investing can be about feelings too.
The second generation of behavioural finance acknowledges that we're all human beings and our decisions are driven by both financial and non-financial wants, per Statman. We want returns on our investments so we can retire comfortably, but we also want to do it in a way that aligns with our beliefs and principles. It's about taking non-financial desires into consideration, even if it means potentially giving up some return, but doing it within reason.
Here are three examples on how to balance financial and non-financial wants:
- Home bias: Investors with home bias prefer to overweight their own country's stocks. While there may be a rational case for investing half of your stock money in foreign stocks, some investors are hesitant to do so. Some cite patriotic reasons, others are not comfortable investing in companies they don't know. Rather than skipping foreign stocks altogether, and losing out on global diversification, Statman says why not invest at least a smaller portion in foreign stocks?
- Social responsibility: Common themes for socially responsible investments include avoiding investment in companies that produce or sell addictive substances and looking for companies involved in social justice, environmental sustainability and clean technology efforts. People who invest in a socially responsible way combine two goals: they want social impact and financial gain. And with client demand on the rise, sustainable investments surged by more than $2 trillion in the last two years.
- Status symbols: Finally, some investors value owning specific products, such as hedge funds, because they convey a high status in certain social circles. “Acknowledge that a hedge fund may be enticing as a badge of high status, but also take a cold look at the fees," says Statman.
Looking for some sound, unbiased advice for your investment portfolio? Find an experienced financial advisor in your area who can help you navigate both your financial and non-financial wants.