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Invest

The psychology of investing

April 28, 2023
4
min read

By understanding how your emotions affect your finances, you can better prepare yourself for the ups and downs you may experience as an investor.

Woman writing with paper and pen

You might think that investing is all about numbers. However, you can’t overlook the role that emotions play in your investment portfolio.

In 2022, many investors saw their portfolios take a nosedive. Even bonds, considered to be one of the safest parts of an investment portfolio, had their worst year in decades.

After a bear market—a period where stock prices drop by 20% or more—it’s natural to feel scared to invest. Some might wonder if they should pull their money out completely.

What makes investing so scary?

Money helps us reach long-term and short-term goals; it ensures we can support ourselves and our families.

When markets fluctuate, so does our sense of security—and that’s when fear creeps in.

“Emotions play a huge part in how people invest and their thoughts on investing,” says Crystal Brown, Senior Financial Advisor at Cambrian and Aviso Wealth.

“As humans, we may intelligently get how something works, but that is not always how we react.”

Fear makes it difficult to invest wisely and reach your financial goals. One way to reconcile a fear of investing? Arm yourself with knowledge.

Let’s take a closer look at what happens in our brains when we invest our money and explore common cognitive biases, with advice from Crystal Brown:

Loss aversion

Would you rather find $50 on the ground, but later lose $20? Or would you rather find just $30?

Even though the outcome is the same, most people would pick the latter. This is because of loss aversion.

Loss aversion describes how the negative emotions you feel when losing money are more powerful than the positive ones you feel when gaining it.

When it comes to investing, loss aversion describes our tendency to try to avoid the pain of losing money.

But without taking on some risk in their portfolios, some investors may not be able to reach their long-term financial goals.

Regret avoidance

Many investors sell too early when the going gets good.

For example, let’s imagine you bought $100 worth of stock in an electric car company. Next month, the same stock is worth $125.

Based on current market conditions, you know that it’s likely that the value will continue to rise.

But rather than ride out the win to see bigger potential returns, most investors would sell early—just to ensure they avoid a loss and don’t end up regretting their choice.

This tendency can cause investors to miss out on greater gains.

Sunk cost fallacy

Image that you purchased $100 of stock in an oil company. Four months later, those shares are valued at just $20. After doing some research, you can only find more evidence that the company’s value will continue to plummet.

Would you cut your losses and sell? Or hold out and hope for the company to make a rebound?

Due to the sunk cost fallacy, some investors would keep holding on, because deciding to sell makes the loss permanent. Hold on to the investment, and there’s still a chance—a slim chance—that you might recover those losses.

But if an investor can’t cut their losses when it’s time to do so, they’ll continue losing money. This is why the sunk cost fallacy can hurt your investment portfolio.

“Manitobans like to get a deal—they will even buy something they don’t need because it’s on sale,” says Crystal.

“But when it comes to investing, we tend to do the opposite. We know we should sell high and buy low, but we panic and do the reverse.”

Anchoring bias

These days, there’s so much information online about investing that it’s tough to know where to get started.

To anchor our thoughts, we tend to put too much significance on the first piece of information we find—and we ignore new or contradicting information.

Here’s how anchoring bias ties into investing:

Today, a company’s shares are valued at $50, and you decide to buy in.

The next week, they’re valued at $25. As time goes on, you keep waiting for the value to climb back to $50.

That’s because you’ve anchored the initial price, and it will now influence how you view the stock’s value moving forward.

The market is always changing; we need to be able to adapt and take in new information as it comes to us, rather than relying on our first impressions alone.

Assessing your risk tolerance

Risk tolerance refers to how comfortable you are with market volatility in your portfolio.

Taking on more risk means you have the potential to make greater gains.

But it also means you could experience greater losses.

Everyone’s risk tolerance is different. It depends on many factors, including your financial goals and investment timeline.

“Risk tolerance is a combination of tolerance and capacity,” says Crystal. “You may have the tolerance for risk, but financially, can you afford to take that risk?”

To figure out your risk tolerance, you can ask yourself questions like:

  • What’s your time horizon? Do you plan to use the money in 1 year, 3 years, or 30 years from now?
  • What do you plan to use the money for? Is it to fund your next vacation or your retirement?
  • If your investments dropped in value by 50%, would you wait out the market dip or pull out all your funds?

Meet with a financial advisor at Cambrian today

At Cambrian, we can help you build an investment portfolio that’s tailored to your unique situation.

“When I meet with members, I find out what they are saving for and look at their whole financial picture,” says Crystal.

“Then, I can determine what type of account(s) would be best suited for them.”

Book a meeting with a Cambrian advisor today!

Disclaimer

Mutual funds and other securities are offered through Aviso Wealth, a division of Aviso Financial Inc.

Today’s Rates

*All rates and yields subject to change without notice.
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