The emotions that people can experience when buying equities is well illustrated by the example of GameStop shares. The story: demand for the products of the US video games retailer had been plummeting for some time. This attracted speculators looking to cash in on the company’s demise. They borrowed GameStop shares, sold them immediately and then bought them back at a lower price.
Making hasty decisions on buying or selling equities is ill advised.
There’s no room for sentiment on the stock exchange: decision-making based on emotions is foolhardy and runs the risk of making losses. The hype over GameStop shares highlights how private investors can get caught up in the hype and who ultimately benefited from turbulent conditions on the stock market. One thing’s for sure: it certainly wasn’t private investors.
Gamblers, followers and ideologists
But outside of the speculators’ field of vision, small-time investors urged one another on social media to invest in GameStop to drive the share price up. But without good reason for doing so – the investors acted emotionally. Some wanted to wipe out the speculative hedge funds by thwarting their plans. Others wished to help save the company. A few tried to benefit from the rising prices while some simply jumped on the bandwagon because they didn’t want to miss out on the action.
But experts know that when investing, it’s vitally important not to be led by your emotions or to act hastily. Otherwise you run the risk of investing or selling at an inopportune moment. Emotional investors focus on short-term price trends. But they’re unpredictable and volatile. Trends can often only be identified over a certain period of time and generally only explained in retrospect. That’s why it’s important to have a clear investment strategy that you stick with long-term – especially if prices rise or fall sharply in the meantime.
Emotions stand in the way of success
Economists have determined a whole range of emotions as part of the behaviour-oriented financial market theory which prevent investors from enjoying success on the stock market. The key ones are outlined here:
- Impatience: people expect to make rapid gains over a time period that’s too short. They are only generally achieved over time. Short-term losses can also be made.
- Fear of losses: Equity prices don’t just go up, they can also fall. People are much more aware of losses than gains. Psychological analysis has revealed that if gains and losses are made to an equal extent, people notice the impact of losses twice as much as that of gains above a certain amount.
- Overconfidence: People overestimate their abilities because they think they’re better than average. They also overrate their judgement on the stock market.
In an economic crisis, fear of losses and overconfidence are the most dangerous behavioural tendencies. People who overestimate themselves focus on particular equities and believe they can make strong gains quickly – instead of generating a long-term return from a well-diversified portfolio across the whole market. Falling prices lead people to act impulsively, often causing them to sell equities out of panic.
More investors – fewer gains
There are other signs of irrational investment behaviour too. They include herd mentality: if lots of people tip a share or sector to make strong gains, this can entice more people to invest their money there. The chance of making gains is reduced if lots of people invest. The downside risk also grows as speculative bubbles are created.
This is illustrated by the case of GameStop. The success stories posted by investors on social media and the activism against the hedge funds gained such momentum that more and more small-time investors jumped on board. But only those who quickly sold on their shares made a profit. While some hedge funds actually ran into trouble, the company GameStop and online brokers, such as RobinHood and Trade Republic, were ultimately the winners from this campaign.
Thanks to the attention generated on the stock market, GameStop was able to briefly sell a billion dollars worth of shares and increase its revenue by a quarter. The hype enabled online brokers to significantly expand their user base, increase the value of their companies overall and make significant gains through the greater number of transactions.
Instead of speculating short-term, investors are better advised to make long-term, well-diversified investments and to adopt a strategy that takes account of personal risk capacity and appetite as well as the investment horizon. Investors who opt for a savings plan with an investment fund can benefit from the average-price effect. Fewer shares are purchased from the contributions regularly paid into the investment funds when prices rise, whereas more are acquired if they fall – this means the average price is paid for the equities concerned. This reduces the risk of starting to invest at an unfavourable moment.
Warren Buffett’s advice on index funds
Emotional reasons are the main cause of losses on financial investments. People seeking to make a quick buck with short-term decisions are often disappointed. The highly successful US investor Warren Buffett advises investors unable to sufficiently focus on the equity markets because they lack the time or expertise to invest in index funds.
Warren Buffett’s advice is: “If you like spending 6-8 hours per week working on investments, do it. If you don’t, then dollar-cost average into index funds. This accomplishes diversification across assets and time, two very important things.” Buffett favours attractively priced index funds where you don’t invest a large amount in one go, but pay in small contributions over several years. To build up assets long-term, look beyond market hype and trends and focus instead on a long-term investment horizon.