By Justin Moore
When the market takes a dive, are you more likely to change course or stay the course What about when the market is rising
Are you more likely to follow the crowd and buy more or do you maintain your investing strategy?
If the answer to the first question is changed course and the answer to the second is follow the crowd and buy more, you could be letting your emotions dictate your investing. Emotional reactions often cause investors to buy high during the exciting phase of a market bubble and to sell low during a down turn when panic sets in, exactly the opposite strategy of what successful investors are supposed to do.
Although the ability to analyze situations and make quick, emotion-based decisions was necessary to survive in mans primitive days, generally its not appropriate when investing in the stock market. Fear of loss and anticipation of gains are STRONG human emotions that are studied not only by behavioral finance researchers but also by neuroscientists.
Now independent research studies suggest two areas of the brain, one that controls fear and another that seeks reward, likely drives emotional investor behavior. In one study of why some people double-down on gambles that could lead to gains, researchers at Calif. Institute of Technology examined the reactions of patients who had a genetic condition that damaged a structure of the brain known as the amygdala – the brains fear center – compared with reactions of a control group without amygdala damage.
In a series of monetary gambles the patients with damage to the amygdala invariably chose the riskier option. In fact, the participants with amygdala damage demonstrated NO aversion to lose, which contrasted with the more cautious group. Researchers concluded that a fully functioning amygdala appears to make us more cautious.
Does this mean that emotion has no place in prudent investment decision-making?
Although a healthy sense of fear and a drive to succeed are necessary for sound decision making, these emotions may NOT guide investors correctly and could end up in losses over the long run compared with a more disciplined approach.
Instead, investors should focus their approach on understanding how a sound, diversified strategy can lead to success when following impulses can fail. There are several things that investors should keep in mind.
The first element is the time horizon, or how long the investor has before they achieve their goal. Investment is generally a long-term source of profit, and some investments may not show rewards for months or even years.
The second major element that investors should focus on is their risk tolerance, or how well they can endure the failure of the investment. In general, money should never be invested unless it can be written off in the event of failure, while some individuals may have a greater tolerance for risky investments than others. Many portfolios work to balance these items by combining several stable, long-term investments and using the profits from those to invest in higher-risk areas that offer greater rewards over time. If the return is high enough, even a high rate of failure may remain profitable.
Finally, investors should consider their personal circumstances when making their financial decisions and focus on investments that fit in with their needs and desires.
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