Common sense may say that the time to invest is when markets are down, but the reality is that most investors wait until markets are running hot before they get on board.
The psychology of an investor plays a significant role in what drives financial markets and explains in part why the prices of many assets, including property and shares, go through booms and busts.
Two common characteristics of human behaviour that tend to play havoc with many investors™ decision making and investment markets are fear and greed.
Fear may prevent you from buying something when it appears to be out of favour because of the possibility of losing money. Greed may encourage you to aggressively chase returns into investment opportunities beyond your normal comfort level.
Rational investors may be less worried about the risk of losing money in the short term. They are more focused on the possibility of long-term gains based on their view of the company and broader economic conditions. This person may invest regardless of what the market is doing. The same investor might prudently rebalance their portfolio back to a desired asset allocation using an objective rationale.
Rather than make decisions rationally based on available information, most investors left to their own accord are much more likely to let their emotions drive at least part of the process.
It is because of emotion that most investors sell when markets are close to their bottom and buy when markets are nearing their peak.
Loyalty doesn™t always pay
Feeling loyal towards an underperforming company just because you have held the shares for a long time is no reason to keep them. Nor is buying shares in a company just because you are envious of others having them.
There are numerous investor behaviours that may be hard to identify and control. It may be dwelling on what has happened in the past as an indication of what may happen in the future or getting carried away and making over-zealous decisions when markets are running hot.
Reactions such as these can be common, particularly when markets are going through periods of boom and bust. It is important to understand that investment markets are driven by more than just fundamentals and that investor psychology plays a significant role.
Just by understanding emotion and logic, this can play a vital role in the decision making process and can go a long way in helping you make rational decisions.
There are several common biases that have been identified by psychologists as influencing investor behaviour; once recognised these biases may be resolved:
4. Loss Aversion:
Source: ˜Three behavioural biases that can affect your investment performance™, CFA Institute, 2011, viewed 26 March 2013.
The highly successful US investor Warren Buffett turned the phrase œbe fearful when others are greedy and greedy when others are fearful knowing that investors don™t always act rationally and when money is involved, emotions can run high.