Emotional Investing Can Cost You: What It is and How to Avoid It
Of course, some investors lose money because of bad investments. But many lose money because of poor market-timing decisions that are driven by emotions. Studies show that investor portfolios, whose decisions are driven by emotion rather than rational thinking, often lose a significant portion of returns. Let's try to understand emotional investment psychology and learn how to take emotion out of the investment to prevent costly decisions.
What is Emotional Investing?
Emotional investing is buying or selling investments based on the market movements rather than on any fundamentals of investing. Examples of emotional investing are making decisions based on fear of losing money when the market goes down or on a desire to cash in when the stock market rallies, completely disregarding the risk tolerance. Fear of missing out (FOMO) and following the crowds, also known as the bandwagon effect, can also be considered emotional investing.
In investing world, emotions are categorized as two behavioral patterns - fear and greed. Panic caused by fear is rarely a good investment strategy, neither is greed. Fear and greed can have significant effects on the performance of investment portfolios.
Why Emotional Investing Could Cost You
Emotions make it hard for investors to ignore market movements. Greed and fear is the main reason many people are buying at market tops and selling at market bottoms. Investors governed by emotions, sell assets at a loss during downturns, only to pay premiums for the same investments after financial markets show a strong history of gains. Unsurprisingly, this causes their portfolios to underperform. Even inexperienced investors should agree that buying high and selling low is a terrible investing strategy.
Moving into cash by selling assets at a loss and reluctance to invest when markets are in decline with assets sold at a discount - costs investors a significant portion of returns. Research shows that portfolios of investors who invest consistently and stick to their plan, perform 17-23% better over a 10-year period than portfolios of those who base their decisions on emotions (Wendel 2018)1.
Maybe you've already heard that for most investors, timing the market is a futile strategy. Emotional investing is based on timing the market, and when there is no other rationale than fear or greed - one should not expect good results from such a strategy.
Time in the market beats timing the market.
Moreover, it is not uncommon for people to give up on investing after they lose money during a difficult time in the market. It's especially true for young and new investors, who only witnessed a market rally and are not emotionally prepared for prolonged volatility and market downturns. Letting volatility permanently close the door on investing can be a much bigger loss.
Having an actual investing plan and strategy will help combat emotional investing and avoid impulse decision-making.
How to Avoid Emotional Investing
We are humans - to be emotional is our nature. It's unlikely you will be able to suppress your emotions and be in total control of them. And that is OK. What investors should try is to be less impulsive in their financial decisions.
The first step in avoiding impulsive decisions is having a well-defined investment plan and a commitment to stick to it. You already have an investment strategy, right? If you don't have a financial plan, you may want to develop one starting right now. A financial plan will keep you on track with a lot less stress and regrets later. It will help you understand what you want to achieve, how you are going to achieve it, understand your risk tolerance level, and also help you deal with "what if" scenarios.
Your plan should include your financial milestones and investment horizons, as well as expected returns that are reasonable and linked to your investment horizons. Your goals and the length of time that you are willing to hold your portfolio will help determine your asset allocation and risk tolerance. Long-term investment goals allow taking more risk for potentially better returns, as your money will have more time to grow and recover after substantial downturns. Your situation may require a different asset allocation for your short-term goals that don't involve too much risk.
The more well-defined an investment plan you will have, the more likely you will stick to it. Without a well-defined plan, you could choose investments that are too risky for your goals, or you could fall short if you play it too safe and miss out on growth for your long-term goals, such as retirement savings. Of course, your plan may change many times over your investment career, but the changes shouldn't be made on impulse.
Related: Developing Your Investment Strategy
Your plan can also include investment strategies that can help mitigate risk and keep emotions in check.
Strategies to Take the Emotion Out of Investing
Here are a few approaches that investors can implement into their plans to make consistent decisions that aren't driven by emotion.
Dollar-cost averaging (DCA)
Dollar-cost averaging is a strategy where equal amounts are invested at regular intervals. For example, investors can set up monthly, bi-weekly, or weekly recurring transactions. This strategy allows investing in any market conditions and ensures that investors avoid the potential mistake of investing a large lump sum at the wrong time. In a downward-trending market, investors are purchasing assets at continuously lower prices. During an upward-trending market, the assets previously purchased at a lower price, appreciate in value, and fewer assets are bought at a higher price.
Dollar-cost averaging is also a great technique for investors who automate their contributions. For example, investing a fixed amount from each paycheck to 401k or setting automatic transactions to buy mutual funds.
Diversification is the practice of spreading out investments across different types of assets, industries, and geographies. Typically, it's not a good idea to pour all investments into one company, one asset type, or even one sector because it can make a portfolio vulnerable to the adverse effects of just one event. The goal of diversification is to limit the negative impacts of investments that may suffer more than others.
In a diversified portfolio, the losses in some investments can be offset by gains in others. Diversification doesn't guarantee protection from losses, however, it minimizes the chance of a catastrophic loss. Different market conditions may favor different investments, and a diversified portfolio that is made of various types of investments can provide some protection in a range of market conditions.
More aggressive allocations, such as portfolios of 100% stocks, lead to better returns over the long term. But aggressive allocations can be incredibly volatile, and very few investors can tolerate the volatility of a 100% stock portfolio. Drastic moves in one's investment portfolio may lead to an increased likelihood of panic and irrational decision-making. A way to moderate the impact of volatility and emotions is to maintain some balance and own various types of assets. Reduced volatility of a portfolio can help with controlling emotions, making it easier to stay invested.
Design your overall asset allocation that makes sense for your financial and emotional situation and age. Keep in mind, that different assets perform differently, which will change your initial asset allocation at some point. Your financial situation may change as well, prompting the need to change your asset allocation. You may need to rebalance your portfolio periodically and bring it back to the planned asset allocation. If you aren't sure what to do or unable to make a decision, hire a professional to help you.
Read more: Diversification: Important Concept in Investment Management
Tune Out the News
During market volatility, social and mass media bombards us with emotionally loaded impressions of events, and market forecasters spring up like mushrooms after a rain. We get a constant stream of information, and it's easy to get entangled in hype or fear.
Research shows that perceived risk and volatility caused by an abundance of negative information may be substantially different from actual risk (Davies and Brooks 2014)2. The more investors are exposed to such information, the more emotionally loaded it is - the more "real" the risk and volatility feel.
News doesn't necessarily need to be bad to cloud your judgment. This applies to good news as well. An excess of optimism may be as harmful as panic. When you hear that markets are climbing up and every sector is doing great, or when it seems that everyone is getting rich from the next hot investment while you are plodding away, - you may find yourself overwhelmed by fear of missing out.
No news channel or forecaster can accurately predict what markets will do in the short term, not to mention what will happen in the distant future. Reacting to the breaking news can be a sign that your decisions are driven by emotion rather than rational thinking. Tuning out the news, or at least taking everything you read and hear with a grain of salt, can be a good strategy for avoiding irrational decision-making.
Don't Follow the Crowd
Wanting to follow the crowd is a natural human instinct that can make us feel comfortable because we see that we are not alone in our thinking. We are all susceptible to herd mentality and can be influenced to follow and copy what others are doing. When everyone else is selling during an economic downturn or buying when stock prices rise - remember, research shows that crowds are buying at market tops and selling at market bottoms. You want to buy low and sell high, not the other way around.
Average investors greatly underperform the stock market and may not be the best role models for you. The crowd's goals may be very different from your goals. If you feel pressure to make investment decisions based on what others are doing, meet with your financial advisor to review your investment goals.
Stop Obsessively Checking Your Portfolio
Another way to reduce the emotional impact of market volatility is to stop obsessively checking your portfolio. History and research show that for long-term investors it's better to avoid frequent price updates and simply not to peek at their portfolios (Larson et al. 2016)3. Quantifying a short-term loss during a negative market performance will only increase anxiety and may prompt decisions based on emotion alone and make you stray away from the course. Detaching from the fluctuations of your account balances and seeing the benefits of this strategy over the long term will increase the odds of sticking to the financial plan.
The "out of sight, out of mind" approach is helpful for many investors in avoiding mistakes with market timing. It may be beneficial for some investors to take this approach a step further and use target date funds or other "set it and forget it" investments (Holt and Yang 2016)4.
Yes, past performance is no guarantee of future results. But historical data on market performance shouldn't be completely discarded. S&P 500 index has trended upward for more than 65 years. It just doesn't go upward in a straight line. Since its 1957 inception, the index has returned a historic annualized average return of around 10%.
Instead of worrying about short-term losses - look at the big picture.
The Bottom Line
There certainly are bad investments that are susceptible to catastrophic losses but, in many cases, investors undermine their progress by giving in to their emotions. Emotional investing forces investors to time the market, which rarely works. Moving in and out of investments in a volatile market and trying to beat it can be a costly mistake.
Instead, learning about the fundamentals of investing and finding strategies to prevent emotions from taking over and clouding reasoning - is often the key to longer-term success.
It's important to remember that markets move in cycles, and periods of growth can be followed by periods of underperformance. Investing always comes with some risk of loss. Some investments have lower risk than others, but there are no truly risk-free investments.
To mitigate risk, investors should construct an asset allocation that is appropriate for their financial and emotional ability to tolerate risk, which should help with staying the course through volatility. A well-defined investment plan will help to pay less attention to short-term fluctuations and avoid making decisions based solely on market movements.
- Stephen Wendel, Ph.D. 2018. Using a Behavioral Approach to Mitigate Panic and Improve Investor Outcomes, Journal of Financial Planning.
- Davies, Greg B., and Peter Brooks. 2014. Risk Tolerance: Essential, Behavioural and Misunderstood. Journal of Risk Management in Financial Institutions 7 (2): 110-113.
- Larson, Francis, John A. List, and Robert D. Metcalfe. 2016. Can Myopic Loss Aversion Explain the Equity Premium Puzzle? Evidence from a Natural Field Experiment with Professional Traders. National Bureau of Economic Research working paper 22605.
- Holt, Jeff, and Janet Yang. 2016. 2016 Target-Date Fund Landscape. Morningstar research library.