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How to avoid emotional decision making

Keep your head when those around you are losing theirs
How to avoid emotional decision making

As investing gets easier and cheaper, concerns are growing that the stock market is increasingly being treated like a casino. The frenzy over so-called meme stocks shows the extreme end of market madness, with struggling cinema chain AMC Entertainment’s (US:AMC) shares defying any conventional logic to reach a high point of $72 (£50.85) last week – up from $2 at the start of the year. 

Fortunately, I doubt Investors’ Chronicle readers are turning to Reddit’s WallStBets page for sensible long-term investment ideas, the lead forum where meme-stock traders congregate. But that’s not to say that you are free from the risks of emotion-led decision making, which could throw your financial plan off course. 

The rise in private investor activity over the past 18 months has been remarkable, both in terms of people setting up accounts and existing investors dealing more often. Multi-asset investment platform eToro’s results last week revealed that customer trading volumes were 233 per cent higher in the first quarter of this year compared with the same period last year, with roughly 300,000 people in the UK joining the platform in the first three months of 2021.

While eToro has been boosted by its provision of crypto assets, traditional platforms have seen a surge in dealing volumes, too. Hargreaves Lansdown’s latest results reported 6m share deals over the first four months of this year, up from 4m in the same period last year, providing a “key driver” of revenue growth.

It’s not surprising dealing volumes rose as market volatility threw up opportunities, but having a clear investment plan and sticking to it should help you avoid getting swept up in any hype. Broker IG (IGG) recently published a study which analysed how psychology affects trading by taking a range of emotional traits and assessing their influence over a trader’s performance. Fear, greed, hope, frustration and boredom all proved common detrimental psyches that can hinder performance.

Greed and fear are probably the two emotions that result in so many people buying when markets are high and selling when they are low. A simple strategy that can help you to remove biases from your behaviour is to commit to investing the same amount over fixed periods of time – known as pound cost averaging. Not only does it mean you get more shares when the market is lower, it also prevents you from trying to time the market, something often driven by emotion. 

The other point, which we frequently stress, is to make sure that your portfolio is diversified. It sounds obvious, but if a part of your portfolio has severe price falls, inevitably the emotional toll is much less burdensome if another part of your portfolio is performing well. Having a diversified portfolio will also reduce the number of alterations you have to make. 

IG suggests that a way to prevent having your judgement clouded by emotion is to place stop orders to limit potential losses and limit orders to lock in profits, perhaps using fundamental and technical analysis to decide at what level the orders should be placed.

You should also have a plan for all new investments, and write down the reason why you invested in them so you can refer back to it in subsequent portfolio reviews.  

For more guidance on how to overcome your biases, read Algy Hall’s Tame your brain feature.