THE BLOG
09/12/2013 02:48 pm ET | Updated Nov 12, 2013

How Emotions Can Affect Your Investments

If you want to be a better investor, you may need to start using your feelings.

The conventional wisdom, as you may have heard, says that good investing is devoid of emotion. Investing is supposed to be a cool, rational discipline. It's supposed to be free of the dynamics of feelings, based solely on a sound analysis of income statements, cash flow, and balance sheets.

The conventional wisdom is wrong.

The truth is that if you understand how you feel -- what makes you think the way you do, and what kind of personality you have -- you'll gain more insight into how you select your investments. As a result, you could become a better investor, not a worse one, by getting in touch with your feelings.

Here are a few questions to help you understand how your feelings influence your investments.

How much are you prepared to lose?

Suppose you have a portfolio that has a 50 percent chance to double your money over one year. However, that same portfolio also has a 50 percent chance of dropping in value by X percent.

Question: what's the maximum number you're willing to accept in place of that "X"? Is it 20 percent? Is it 30 percent? How much of your current standard of living, or your projected retirement standard of living, are you willing to lose to make an investment that has a 50 percent chance of doubling your money?

The less of a standard of living you're willing to lose, the more averse you are to risk. You'll think more about losing money when evaluating investments than you will about the potential for gain. That fear of loss is emotional, and it affects how you invest.

Are you bothered by bad choices?

This is a question about regret. Do you really hate it when you've made a bad investment decision? Do you look at other alternatives that were available when you made the initial investment and imagine what could have happened if you had selected one of them?

If you have an excess of regret, it may tempt you to shy away from future investments. Again, this is how your feelings are influencing your investment decisions. The next time you see what could be a great investment opportunity, you might be subconsciously thinking, "It looks good, but I don't want to make a bad investment again." That will influence your decision.

Do you believe you're better than everybody else?

You might have a high level of self-confidence. Perhaps you've noticed that your mind is keen and you tend to be sharper than almost everybody you know. As a result, you might believe you're more likely to generate big returns in the stock market.

If that statement describes you, then your bloated belief in yourself might lead you to make some risky decisions. It's another way that your feelings influence your investment choices. In this case, overconfidence can lead to some bad investment decisions and some monetary loss.

The simple truth is this: It's unlikely you're going to beat the market. You might have a sharp mind, but you'll probably end up with returns in line with the S&P 500 if you opt for sound investment decisions. If you take needless risks, you'll probably end up losing money, no matter how smart you think you are.

Do you pay attention to detail?

Are you well organized and thorough in how you conduct business? Are you the kind of person who always pays close attention to detail to be sure you don't miss anything?

If so, then you're conscientious. If that's the case, then you're more likely to hoard money rather than invest it. You want to be absolutely certain you have enough for retirement, so you play it safe. It's another way that your emotions guide your investment choices.

If you're conscientious, you're more likely to be a miser than an investor. It's not necessarily bad to have a conservative investment philosophy, in which you minimize loss by minimizing investment. Still, you want to be sure you're not sacrificing the potential for a decent return because you have an inordinately high percentage of your portfolio in cash.

In a nutshell, you might need a more balanced approach.