Avoiding emotional investing: Strategies for better decision-making
When we speak about financial markets, the language we use is largely based on numbers.
For everything from market capitalization to earnings estimates to share prices to year-to-date performance—and most importantly, our portfolio’s profits and losses—we frame our finances using some form of the cold hard science of numbers.
And yet it’s this hyper focus on the math of the markets that leads many people to form a blind spot in their pursuit of profits. Traders often underestimate the negative impact of emotional investing.
Key Points
- Emotions can subliminally affect your investing decisions.
- Gaining self-awareness is the first step in managing your financial emotions.
- Tailor your trading and investing strategies to your emotional self.
The allure of quick gains—and the fear of losses—can lead traders and investors astray. Impulsive actions can sabotage their long-term goals. The journey toward financial success requires not only a deep understanding of market dynamics, but also mastery over the emotional side of trading psychology.
Strategies to combat emotional investing
Emotional investing is a by-product of an inherent human quality: We react strongly to events that affect us financially. Fear and greed can cloud traders’ judgment and cause investors to deviate from well-thought-out strategies.
The root source of these emotions can be complex, and exploring them is a lifetime journey. But there are some ways you can minimize their impact, even without fully understanding what causes these emotions.
Cultivating emotional intelligence through mindfulness
Mindfulness, an ancient practice rooted in meditation, has found a modern application in the financial world. The practice involves focusing your attention on the present moment, fostering awareness of thoughts and emotions without judgment.
For example, you may be prone to revenge trading—that is, taking an ill-advised or impulsive trade for the sole purpose of recouping money from a losing trade. But just the act of noticing when you’re about to do so can help break the cycle of emotional reactivity.
The goal is not to eliminate the underlying emotions that drive emotional investing. That’s not possible, unless you’re a robot. But by observing emotions as they arise, acknowledging them, and allowing them to dissipate, you’ll be better able to respond thoughtfully rather than react impulsively.
Tracking the cycles of emotion
Understanding your emotions requires active self-reflection. Keeping a trading journal is a powerful strategy that can help. By regularly recording their trading decisions, thought processes, and emotional states, traders and investors can begin to identify the patterns and triggers of emotional investing.
This practice, used in conjunction with mindfulness, will help in recognizing and managing emotions as they arise. In addition, seeking feedback from mentors or peers provides an external perspective that can uncover hidden biases and emotional blind spots.
Tailoring strategies to your personality
You can also avoid emotional investing by tailoring strategies to your personal disposition. Not all strategies resonate equally with everyone. You can align your trading approach with your temperament, risk tolerance, and financial goals.
For instance, if you’re totally risk-averse, you might opt for long-term value investing. Someone with a higher risk tolerance might delve into shorter-term strategies such as day trading or swing trading. If you’re comfortable with probabilities, you might use options to target your profit and loss objectives. Customization reduces the disconnect between personal inclinations and trading strategies, promoting consistency and rational decision-making.
Mechanical trading: Rules over emotions
Creating a mechanical trading system can act as a safeguard against emotional investing. Predefined rules that dictate when to enter or exit a trade help eliminate the need for on-the-spot decisions. This can help traders curb the influence of emotions.
Trading system rules might include technical indicators, risk management thresholds, and profit-taking targets. Adhering strictly to these rules enforces discipline and minimizes the potential for erratic actions driven by emotions.
The illusion of universality
Amid the allure of financial success stories, there exists an unspoken assumption that trading and investing are universally desirable pursuits. But not everyone possesses the psychological makeup or temperament best suited for the rigors of trading.
The immense pressure, constant vigilance, and inherent uncertainties of trading can take a toll on your mental well-being. It’s crucial to acknowledge that success in trading might not equate to personal fulfillment. The pursuit of financial goals should align with your broader life aspirations.
There’s a well-known story that, though possibly apocryphal, illustrates this point:
A reporter goes down to the floor of the New York Stock Exchange to interview a highly successful trader. After the interview is over, the reporter says, “Can I ask you one last question?”
“Sure,” says the trader.
“You’ve been trading for over 20 years now. Every day you get up at 4 a.m., fight the traffic into the city, spend most of your time shouting and shoving against your rivals in the pit, all while dealing with the gut-wrenching anxiety and pressure that comes with trading. Then you stay late to reconcile your trades, don’t get back home until well after dark, and hardly ever see your wife and children.”
“Yes,” says the trader.
“So why do you still do it?” asks the reporter. “You’re worth a hundred million dollars. If I was worth a hundred million dollars, I’d be retired on an island somewhere.”
The trader pauses for a beat, then says, “That’s why you’ll never be worth a hundred million dollars.”
You might find this story inspirational, or you might find it repulsive.
But the point is that for some people, the emotional—and personal—sacrifices required to achieve certain goals aren’t always worth it.
The bottom line
Mastering emotional investing requires a multifaceted approach that intertwines self-awareness, mindfulness, personalized strategies, and a candid evaluation of personal traits. But in a world inundated with stories of overnight fortunes, remember that not everyone aspires to be the richest person in the cemetery.
The pursuit of wealth should harmonize with your emotional well-being, as well as with your individual aspirations and capabilities.