According to the critically acclaimed Sun Tzu’s Art of War, “if you know your enemies and know yourself, you will not be imperilled in a hundred battles”. This statement not only applies to war but also to investing. It is safe to say that many investors do their homework before making an important investment decision. However, how many investors dare to say that they truly understand themselves and how their own emotions can influence their behaviours and decision-making processes?
Many of us love to believe that we approach our finances methodologically and rationally. Unfortunately, this is rarely the case (especially for novice investors). Emotions play a significant role in influencing our cognition and behaviours. When emotions come into play, it is highly probable that we will fall prey to irrational decision making.
Although it is impossible to absolve ourselves from our innate emotions, being cognizant of our feelings allow us to anticipate and react appropriately to make better decisions. When we are more aware of how our feelings can affect us, we will be less likely to make irrational financial decisions.
The 14 Stages of Investor Emotions
Depending on how well or bad the market is performing, we will experience a myriad of different emotions which in turn will affect the financial and investment decisions we make.
According to most behavioral economists, investors usually go through these 14 different emotional stages depending on how the market fares.
It all starts with the market performing generally well. As the market performs well, we tend to feel optimistic about it. When we feel optimistic, we are more inclined to invest and commit ourselves to the market
“STI closed 2 per cent higher in a few consecutive weeks. Now is the right time to enter the market.”
When the market continues to move in our favour, we can’t help feel excited. With this excitement, we fantasize and consider what we can accomplish.
“Oh my God! This is definitely one of the best transactions I ever made! What if I this transaction makes me the next Warren Buffet?!”
With a bullish market in play, we can’t help feel proud of the achievements we have made. At this phase, we start to trust the market; we have confidence in the transactions that we have made.
“I knew I was right all along! I told you guys to follow my transactions!”
- Euphoria (Point of Maximum Financial Risk!):
As the bullish market moves its’ way to the peak, euphoria sets in. Our investments turn into sizeable profits. Having tasted success, we become less risk averse start to trade more to improve our portfolio. That being said, we also begin to ignore our fundamentals; we start to neglect risk and expect all investments to be profitable.
This is the point where there is not only maximum financial risk but also maximum financial gain. As we gain more, we become less risk averse and take on more financial risk.
“Look at the profits I’m raking! I think it is time for me to investment more in other companies too! Or maybe I should invest more into the companies in my portfolio? Whatever it is now is definitely the right time to make some money.”
Trends of reversal start to show up. The profits of our transactions start to dwindle. Never seen the market acting against us, we tend to remain positive and expect that the long-term trend is still on our side. This is also the point where we convince ourselves that we are long-term investors and this is perhaps a one-time occurrence.
“Don’t worry! This is not going to affect us in the long-term. We are long-term investors! The companies that we invested in are the good companies and won’t be affected in the long term.”
When the market continues to move against us, we become stupefied. Despite telling ourselves that we are long-term investors, we secretly hope that the market turns into our favour soon. After all, who would be happy to see unrealized losses in their portfolio?
“Oh no…! What is wrong? Did I make the wrong investment choices? Will my investments ever turn the tides?”
Feelings of fear start to show up. The market becomes confusing for us to comprehend. We start to realize that perhaps the investments we made were not actually that smart after all.
“Maybe those companies are not as fundamentally strong as what I thought…”
With the market continuing its’ downward spiral, we jump at every opportunity that may bring our position out of the deep red sea of losses. At this point, being able to break even any losses made would assure and calm us down.
“Should I try using the dollar-cost averaging method? Will this method will allow me to escape the market unharmed? What if it works?!”
In this phase, we are at our wits end. It feels like the world has come apart and we are at a loss of what to do. We await the verdict from the market and we are in total control of the market’s performance.
“What should I do…?”
Finally, the verdict has arrived. We realized and decided that the market will never be bullish again. This is also the point where we decide to cut all losses as we cannot afford to lose anymore.
“I’m selling all of my stocks. If I lose any more money, I will most probably lose all my savings!”
- Despondency (Point of Maximum Financial Opportunity!):
After deciding to exit the market, we swear to never invest again. This is the point where we start to lose out many financial opportunities as we become extremely risk averse. After having a bad experience with investing previously, we view the market with a pessimistic perspective.
“The STI is bouncing back? It may only bounce back in the short-term. I think I shall not dabble in any investments anymore!”
We chide ourselves for being so foolish! This is the point where investors analyse and learn from the mistakes they made in their previous transactions. This is also the phase where true investors are made; some people never get over their losses and stay away from the financial markets entirely.
“Ahhh! How could I have committed such a foolish mistake! Let’s take this as a lesson learnt and not repeat this mistake again!”
As we start to analyse and learn from our mistakes, we realize that the market moves in cycles. We continue doing our homework and start searching for the next best opportunity to enter the market.
“Now I know how the financial market works! I should continue to look out for the next best timing to jump back into the market.”
As the market turn bullish again and we see our investments raking in the profits, we recover our confidence as an investor. With the renewed faith, we start to believe our capabilities as investors again.
“Perhaps I am not as foolish as I thought I was. I just need to be more cautious, astute and assiduous in my research before jumping into making any investments again”
Know Yourself to Make Better Investment Decisions
Many investors who are unaware of how emotions can affect their decisions can find themselves trap in the phase of “despondency”, they are too afraid of investing in the market again. Most of them never move on and shy away from the stock market for a very long time.
This is why being cognizant of the 14 stages of investors emotion is extremely important to all investors who strive to be rational in their decision making. We should all use this understanding of how emotions can influence us to make us better decision makers (e.g. being more critical and demanding of ourselves when we are in the stage of euphoria, and move on and learn when we find ourselves in the stage of despondency.)
PS: I will like to highlight that I am unable to find the original person who conceived the 14 different emotional stages and will like to give credit to whomever he/she is.
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