If you've ever plugged money into a slot machine, you have a sense of just how quickly rationality can evaporate when it comes to money. We know that a slick, shiny machine owes us no favours and that every win or loss is all up to chance. But that doesn't stop even straight-laced individuals from falling prey to all kinds of flawed thinking. If you allow yourself to think about winning big — even for a moment — you're likely to begin to believe that your winning streak will continue. Or that your losing streak will turn around if you just keep feeding coins into the slot.
The same thing happens in investing. For many people, the emotion we attach to it and the behaviour it provokes are strikingly similar to gambling. And like in a casino, the financial markets don't owe you a thing. If you make emotional decisions with your money, you're likely to pay dearly.
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So what can you do to prime yourself for good decision-making — and therefore better investing? Here are a few key tips to keep on the right side of the investing track...
1) Prime your senses
Think about the last decision you made. Were you tired? Emotional? Hungry? This isn't a trick question: how we feel in the moment can drastically affect the decisions we make. This means in order to make good investing decisions, it's important to avoid making them, say, right after your boss criticizes your work or you're running late for an important meeting. No matter how stressed and time-pressed you are, you have to set aside some quiet time for making investing decisions and avoid making them on the fly.
2) Avoid decision fatigue
Sometimes, ordinarily sensible people go off the rails; they rage at other drivers during rush-hour traffic, explode at their spouses and splurge on junk food. And, as you might imagine, most of these indiscretions happen at the end of the day, when low blood sugar and mental exhaustion can combine to leave us at wit's end - literally. Think you can still think on your feet if it's important enough? A 2011 report by Jonathan Levav of Stanford and Shai Danziger of Ben-Gurion University looked at the patterns regarding how parole was granted to Israeli prisoners and found one common factor that affected whether prisoners would be released: the time of day. In other words, those who faced trial in the late afternoon were likely to be thrown back in jail, regardless of what they'd done. Here's why ...
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Making decisions is mentally taxing; each one costs us. As such, the more we make, the less power we have to deliver sound judgment. According to Michael S. Falk, a CFA and partnering consultant at Focus Consulting, it's important to take a break after making a big decision before making another one. So, if you're thinking about selling a stock or making another big move in your portfolio, consider taking a walk, doing some yoga, or even just taking a few deep breaths before you seal the deal. Chances are, it'll affect the quality of your decision and therefore its outcome.
3) Make "if-then" decisions
We're only human. Despite our best intentions, no matter how much we really, really mean to follow through on what we say we're going to do, we often just...don't. So, assuming that you'll react deliberately and rationally when your beloved stock pick makes a run toward worthless is like assuming you'd walk right on by a designer sample sale without slowing down. Not gonna happen.
When it comes to your portfolio, you can set yourself up for success by having a sell discipline. That is, making decisions about how much of a loss you're willing to accept on a stock and how long you'll let it run before selling it. In this way, no matter how angry, sad or betrayed you feel when it doesn't turn out, you'll still be able to make a rational choice about how to salvage your investment — without putting any more of your capital at risk.
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4) Learn from your mistakes
To err is human. What appears to be equally human is covering up our little blunders and pretending they never happened. However, in order to make fewer mistakes, we need to learn from the ones we've already made! This involves admitting to and examining our mistakes - and looking for ways to avoid repeating them. This is especially important in investing. Think about it...what if your approach to choosing or managing securities is fatally flawed? Do you really want to keep losing money for the sake of your delicate ego? Hardly.
Next time you suffer a loss, take a look at your losing investment and try to make some conclusions about what went wrong (bring your financial advisor into this discussion). You should also record your gains and losses to look for any patterns over time. According to Falk, fewer than 10 percent of investors do this — but it's one of the most important steps to improving investing performance.
[More: Buying stocks: Is it time to get greedy? Contrarian investing explained]
5) Focus on your strengths
Give yourself a break: you have both strengths and weaknesses. Just as you're unlikely to get a thrill out of skydiving if you're terrified of heights, your personality will dictate the kind of investing that's right for you. If you're great at keeping a level head and making reasoned decisions under pressure, you might be a good candidate for a fairly high-risk stock portfolio. If you're a top-rate saver but the thought of losing money in the markets leaves you a quivering mess, look to lower-risk options like government bonds and GICs. And if you have a keen understanding of real estate, think about investing in that market, among others. Next, discuss these options with a professional advisor who can put the emotions aside and look at the overall picture and balance of your portfolio — working together with you to maximize its benefits according to your risk tolerance.
Put the odds in your favour
Winning, losing, bringing home the bacon; these are events that feed our most primal emotions. But succumbing to your inner cavewoman isn't exactly the best way to succeed in today's fast paced — and often highly volatile — markets. So rather than tempt fate, why not throw luck and lineage aside and learn to overcome the deep-seated emotions that can destroy a portfolio's outcome? Unlike a slot machine, a portfolio can be stacked in your favour...but only if you resist turning the wheel every time you win or lose.
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