Avoid the emotional investment trap

Your 5-minute guide to investor psychology

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Naturally, you would like to make a profit on your pension and other investments.

Common investment sense would say the best way of doing this is to invest to suit your risk profile and investment time horizon, ignore market noise and diversify your portfolio across asset classes with low correlations. However, in volatile market conditions, like today’s, many of you may be fearful, losing sight of your long-term objectives and getting out of the market when it is falling. As a result, you may be realising losses and damaging your long-term wealth. This article explains the emotions that you may be feeling   – and suggests how to avoid the psychological trap.

The emotional curve of investing

Stage 1 : Market recovery – hope/confidence:  You have just come out of a bear market1. You may still be a little cautious, as you may have lost money or have friends who lost money. While still cautious, you see the market rising and a sense of hope ensues.

Stage 2 : Bull market in full flow – euphoria/greed/buy: As a bull market unfolds, your interest in riskier assets, like equities increases – and journalists comment on the wealth creation opportunities in the market. More companies float their shares on the stock market, as they can raise more capital by issuing shares when the market is climbing. More retail capital is invested, propelling the market higher – with the result that there is a great sense of euphoria. At this stage, you may only see the upside potential of the market. The more it rises; the more achievable profits seem.

Stage 3 : Markets begin to fall – denial: Of course this euphoria often leads to an overvaluation of shares. The market is over-bought – which means that there is no more cash to fuel the bull rally2. So, your investments fall in value. However, the satisfaction of having made profits during a rising market is still fresh. You may still remain confident and are reluctant to accept that the bull market may be coming to an end. You may also remind yourself that you are a long-term investor.

Stage 4 : Markets entering a bear cycle – fear: It becomes apparent that the market has entered a bear cycle, as a correction ensues. Market falls and economic weakness are front-page headlines. You are losing money. Your friends are losing money. Fear sets in. You may become more risk-averse – and your concern shifts from capital growth to capital preservation.

Stage 5 : Markets are bottoming – panic: Panic sets in. You may see your wealth significantly eroded by large market declines. Investors give up on the market in droves, surrendering to bearish sentiment to an extent that involves panic selling and moving into safer investments such as cash. This is called capitulation.

The cycle starts again.

The cost of falling into the emotional investment trap

Time, not timing is the most important thing to consider when investing. The best time to invest is as soon as possible – so your money has plenty of time to grow. Of course, all investors would like to sell at the top, just before the market turns down and then get back into the market at the bottom, just before the recovery begins. However, getting the timing exactly right is virtually impossible, even for seasoned investors.  By the time most investors realise the market has bottomed, it is already too late. Over every market cycle, there will be positive and negative days.  The chart below demonstrates that missing even a few of the best days in the market can lead to significant wealth destruction.

Is a multi-asset fund aligned to your risk profile the right solution?

Peter Lynch, one of the world’s most famous investors once said, ‘the key organ for investing is the stomach and not the brain’. So, when formulating a financial plan with your Financial Broker, you should aim to assess how much volatility you can stand. Will you fall into the emotional investment trap or will have the nerve to sit tight and ride out market lows? Based on this assessment, plus your financial goals and investment time horizon, they can recommend an appropriate investment strategy. If you would like a fund that involves minimum engagement, our range of ready-made Multi-Asset Funds offer you wide diversification, are cost effective, risk appropriate and expertly managed.

Chart 2

Bottom line

Investing for the long-term is the best strategy for generating wealth. Unfortunately, too many private investors tend to follow the herd – unwisely selling when markets turn down and missing out on the subsequent rebounds in the market. At times like these it’s important to keep a cool head, think about the long term, and talk with your Financial Broker about the right investment strategy for you.

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  1. Bear market: A market where the prices of securities are falling, and widespread pessimism causes the negative sentiment to be self-sustaining.
  2. Bull market: A market where the prices of securities is rising, and widespread optimism causes the positive sentiment to be self-sustaining.

The information in this content does not constitute investment advice. It does not take into account the investment objectives, financial position or needs of any particular investor. Before making an investment decision, you should consult suitably qualified and independent investment, taxation, and regulatory advisors to discuss your specific situation and investment objectives. The investment strategies and risk profiles outlined in this document may not be suitable for your specific investment needs.

The funds referred to on this page may be linked to an insurance-based investment product and the Key Information Document (KID) for this product is available at www.friendsfirst.ie/kids or https://keydocs.aviva.ie/ . The Risk Ratings of the funds referred to in this document differ from the corresponding Summary Risk Indicators shown in the KID. An explanation of the differences between the Risk Rating and the Summary Risk Indicator is available at the location above.

Warning: The value of your investment may go down as well as up.
Warning: If you invest in these funds you may lose some or all of the money you invest.
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Aviva Life & Pensions Ireland Designated Activity Company, a private company limited by shares. Registered in Ireland No. 165970. Registered office at One Park Place, Hatch Street, Dublin 2, D02 E651. Aviva Life & Pensions Ireland Designated Activity Company, trading as Aviva Life & Pensions Ireland and Friends First, is regulated by the Central Bank of Ireland. Tel (01) 898 7950.