Part One - The Psychology of Investing: Why Emotion Can Derail Returns
- Eloise Bell
- Aug 12
- 3 min read
When it comes to investing, intelligence isn’t always the issue… emotion is. Behavioural finance shows us that even seasoned investors fall into predictable psychological traps. Sometimes, the biggest risk to a client’s success is themselves - a fact backed by science, data, and experience. As Benjamin Graham put it: “The investor’s chief problem and even his worst enemy is likely to be himself.”
We’re poor predictors of markets, outcomes, and even our own behaviour. Hardwired to seek reward and avoid pain, we become overconfident in rising markets, overly cautious when they fall, and unreliable when it matters most. It’s just how we’re built.
How Emotion Sabotages Investment Decisions.
It’s not just a problem suffered by individual investors – professional fund managers fall into the same behavioural traps on a regular basis. Imagine this scenario: a fund manager buys two highly recommended stocks. One shoots up, delivering double-digit returns in a few short months. The other one disappoints early on and struggles to improve. What does the manager do? They sell the winner, because it feels good to take a profit, and they keep the loser, because they’re hoping, praying, maybe bargaining with fate, that it’ll bounce back. They’ve just fallen into the trap known as the ‘disposition effect.'
The Disposition Effect: A Common Investing Mistake.
First described in 1985 by behavioural economists Hersh Shefrin and Meir Statman, the disposition effect is the tendency for investors to sell assets that have risen in value, while holding on to those that have fallen. It’s entirely irrational, and very common. In fact, it’s one of the most consistent behavioural biases found in investing. And it is a very serious problem when it comes to building long-term wealth.
Let’s break it down further. Selling a winning investment too soon is like subbing your star striker just after they’ve scored a goal, not because they’re tired or injured, but because you’re convinced lightning won’t strike twice. Yes, you’ve scored a goal, but you’ve also upset the rhythm of the team and removed possibly their best chance of increasing their lead and killing off the game. In investing, as in football, the smart strategy is to let your best performers keep playing, because momentum matters, and great players often score more than once.
Equally, holding underperforming investments for too long is like keeping faith with an ageing striker who hasn’t scored in months, just because they were the league’s top scorer three seasons ago. Loyalty is admirable, but football, like investing, is about results. If you don’t freshen up your squad with players who can deliver today, not yesterday, you risk falling behind the competition. Staying competitive means making tough calls, rotating your line-up, and knowing when it’s time to substitute a fan favourite for someone with fresh legs.
How the Disposition Effect Hurts Long-Term Returns.
Bringing it back to the investment world, unfortunately, the disposition effect causes a drag on long-term returns. Holding on to poor performers, out of loyalty, denial or hopes of a recovery, ties up capital that could be reinvested more productively elsewhere. And selling the winners too soon means missing out on future growth. Or as legendary Fidelity fund manager Peter Lynch describes it, “Selling your winners and holding your losers is like cutting the flowers and watering the weeds.”
What Neuroscience Says About Investing Behaviour.
Why do we make these kinds of unforced errors? Because we’re human. Dopamine, the brain’s feel-good neurotransmitter, plays a surprisingly large role in investment decisions. It’s the chemical that fires up when we anticipate rewards, whether that’s a slice of cake, a social media like, or a stock going up. When we invest, dopamine fuels our urge to chase gains, sometimes leading us to take unnecessary risks or jump on trends without doing the homework.
And there’s another dangerous path than dopamine – or lack of it – also leads people down. The absence of reward, or worse, the threat of loss, triggers fear circuits that make us overly cautious, even when logic says otherwise. So, investors swing between greed and fear, high on hope one moment and paralysed by pessimism the next. It’s a biochemical rollercoaster, and without a clear plan or disciplined process, investment portfolios often end up at the mercy of these mood swings.
Understanding why we make emotional decisions is a good start, but overcoming them takes more than awareness. In part two, we explore how to take action, use technology to your advantage, and avoid the pitfalls that stop investors from reaching their potential.
Part two coming soon...
