Investors: why managing emotion is crucial for maximising outcomes

Global share prices have grown significantly since records began, and risen by around 10 per cent a year on average. But equities are volatile with many ups and downs. Falls of 10 per cent tend to happen once a year, and 20 percent losses occur every few years. The good news is that the stock market usually recovers quickly and moves on to further gains.

Reacting to asset loss and risk

Say you have a portfolio that loses 10 per ccent in value during the next 12 months. What's the best way to respond? It may be to wait for share prices to bounce back. But ignoring such losses is difficult. There are often intense feelings of pain, loss, disappointment, regret and anxiety - especially as price corrections are frequently accompanied by "doom-mongering" media reports.

If you are unprepared, these emotions could encourage you to over-react by selling all your shares. You would then miss out on substantial returns when the market recovers. Researchers estimate that such emotional mistakes could cost investors significant amounts over time.

The dangers of panic selling

Christoph Merkle, an associate professor of finance at Aarhus University in Denmark, explains that feelings associated with loss can cause fear and panic selling. But leaving the market at a low point crystalises the financial deficit.

"That's the worst time to make a decision because the unconscious, emotional part of your brain is in action," he says. "My research shows that in retrospect, people generally realise that the temporary losses were not as bad as they believed."

Merkle says this risk is exacerbated by online and mobile access, which allow investors to check their portfolios whenever they want to. As daily returns are negative around 47 per cent of the time, investors are exposed to the experience of loss much more regularly.

Most people are vulnerable to knee-jerk reactions, regardless of their wealth or intelligence. An EY survey shows that 73 per cent of investors change their investment behaviour in response to a fall in portfolio value.

Untangling emotional investing

Christian Bartsch is the owner of bartsch consulting, and lectures on resilience for the Liechtenstein Academy, a personal development institute developed by LGT.

He says that humans tend to focus on threats because this benefited our cave-dwelling ancestors. It's why most people feel the pain of investment losses more than the joy of gains - and are still prone to fight-or-flight responses, even today.

"That pessimism makes sense when dealing with physical threats, but not for modern-day challenges such as investing," says Bartsch.

The psychological problems don't end there. According to Meir Statman, a professor of finance at Santa Clara University and author of "A Wealth of Well-Being: A Holistic Approach to Behavioral Finance", losses can inflict regret - the pain we feel when contemplating an alternative action, such as investing today rather than yesterday.

"Different personalities feel the pain of regret differently," says Statman. "For example, it is higher among people prone to maximisation (always wanting the best), and those who believe success depends on skill more than on luck."

How to regulate our investment emotions

Strategies to minimise regret include acknowledging the role of luck, adds Statman. You can't control everything. Another is to "tamp down" on always wanting the best. One more way is to drip-feed small, regular amounts into the stock market to help smooth portfolio returns.

But once invested, the key is to avoid knee-jerk reactions. Bartsch says we can do this by curbing natural fight-or-flight reflexes, and "resisting the urge to do something, anything, to try and regain a sense of control after a loss."

Forethought is essential. The legendary Greek King Ulysses tied himself to his ship's mast to avoid answering the sirens' calls, which would otherwise have led to his doom. Merkle says that like Ulysses, we should take measures to prevent spontaneous and unreflected reactions.

For example, check your portfolio less frequently. When you do, resolve in advance not to react to ups and downs, or to anxiety-inducing news stories.

He also suggests employing "commitment devices". If you're saving for retirement, you can use a pension fund where money cannot be freed up or moved around easily. However, many investors today want access to portfolios and the ability to change them, so anyone in this situation may need extra strategies to stay on track.

Try studying historical stock market performance to understand how regularly crashes and losses happen, and how these are usually followed by rapid recovery and further gains. Remember your own experiences of stock market tumbles, such as during the Covid pandemic, and how quickly markets recovered. Keeping these perspectives fresh in your mind will help you prepare for shocks.

Think long-term

Bartsch suggests developing personal resilience by learning how to embrace and respond to uncertainty. Specifically when it comes to investment dilemmas, he explains that all short-term decisions use the subconscious, emotional part of our brains. Rational thought comes later. "So always stand back and reflect before reacting to events. Sleep on it, and talk to people you trust, especially your financial adviser."

If you don't already have a long-term plan that aligns your financial needs, goals, and risk tolerance, ask your adviser to help set one up. Creating this plan and reviewing it regularly will help you avoid impulse reactions.

One final tip: keeping a cash buffer and maintaining a healthily diversified investment portfolio should help you feel calmer and respond better by reducing any immediate threat to your financial well-being during market falls.

The roles of personality and bias

Understanding your investor personality is also important. For example, do you tend to react directly and proportionately to the current situation, or are you responding to more deep-seated traits developed in your youth?

Bartsch gives the example of a successful businessman whose parents went bankrupt. That experience made him disproportionately anxious about losing money, even though he had plenty and did not need to worry about short-term market swings.

"Every time we react based on emotions like fear, we are likely not responding to current reality, but to the past," says Bartsch. "If you gain awareness about what shapes your reactions, this will help you temper your behaviour to avoid negative outcomes."

The more you talk to your financial or investment adviser, the better they can understand your needs, personality, and how you react to events - and to risk. This will help them support you better and keep your long-term plans on track.