As an investor, not only do you need to exercise discipline, but you also need to establish a game plan that you commit to following scrupulously. This plan can help you reach your goals, while keeping a cool head when your emotions might lead you to make mistakes. Here’s a short guide to the steps to follow and traps to avoid.
What is a game plan?
Annamaria Testani, Vice President of National Sales at National Bank Investments, compares it to a photo that a financial planning expert might take of your situation at a specific moment in time, in order to make more informed decisions going forward. “It’s similar to a doctor assessing your health to pinpoint a particular problem. The main idea is to analyse the initial situation and determine what the ultimate goal is,” she explains. “When we don’t have a plan, we’re less aware of the mistakes we make and it can be a lot harder to correct them.”
In addition to solid planning, she recommends basing your strategy on systematic investment and saving. “There’s no magic formula for achieving your financial goals. Since past returns are no guarantee of future returns, you need to be disciplined. It pays off in the long term. No one should be expecting a miracle recipe that will produce remarkable results in the short term,” she says.
An advisor or financial planner can help you put this famous plan together. “I am an enormous believer in the value of getting advice,” Annamaria Testani asserts. “Personally, even though I work in finance, I don’t hesitate to surround myself with experts to help me make the right decisions.”
Preventing the impact of emotion
Because it pushes us to follow certain guidelines, a good game plan also helps protect us… from ourselves. That’s because a large number of the bad financial decisions investors make are made on the basis of emotion: worry generated by weakened markets and stock market corrections, or on the flip side, optimism and over-confidence, a refusal to lose, and too-fast or too-slow decision-making are all situations that can lead to emotion in an investment context.
In fact, most of us have a hard time managing the psychological aspects of managing our investments. The study of investor psychology has given rise to what we today call behavioural finance. In other words, the way people make financial decisions and evaluate prospective losses or gains.
At the end of the 1970s, two researchers developed something called prospect theory. According to psychologists Daniel Kahneman and Amos Tversky, we adopt different, irrational behaviours when faced with prospective losses or gains. The theory states that people have a hard time accepting the frustration provoked by financial losses on the stock market, and are prepared to take higher, unreasonable risks to avoid this. But there’s more. The researchers observed that the prospect of a financial loss is not mitigated by that of a comparable gain, and that a loss creates a greater emotional reaction than an equivalent gain.
So, a person would generally prefer to gain $100 than to gain $200 and lose $100, even though the net result of both situations is the same. This allergy to loss can lead investors to uncharacteristic risk-taking behaviour: they’ll hold onto a dropping stock longer than they should in the hopes it will bounce back, rather than limiting their losses by selling immediately. Furthermore, faced with a risky choice that could lead to gains, an investor is likely to choose an investment producing a lower return but that is more secure. So, an investor who needs to invest $1,000 would prefer a 100% chance of gaining $500 than a 50% chance of receiving $1,000 and 50% risk of making no profit.
Time and confidence
The other important impact of emotion on investors’ decisions concerns confidence, and the time it takes to establish it. For example, when the market seems weak and uncertain, we have a tendency to stop investing until our confidence is re-established – this is generally when the market shows certain signs of improvement. This leads us to buy stocks at the exact moment when they are in highest demand, and when we head back into a down cycle and their value drops again, we once again exit the market… up until the cycle turns back up again. When we take too long to decide to buy, we miss out on the full potential gains our stock purchase represents. Result: we make investments that go against the flow of economic cycles.
Opportunism and extreme risk-taking
The other thing that psychology teaches us about this is that investors, even if they are generally prudent, will behave opportunistically and take more risk than usual when they want to make a rapid gain on their stocks, then resell. By doing so, they put themselves in a position counter to their goals, and are using the stock market like a casino. Yet, the events that influence the prospective return of a stock are many and unpredictable, and investors are at great risk of making a mistake in their projections.
Lessons we should all take to heart, so as not to be led by our emotions…