When it comes to investing, it’s easy to get emotional. Market volatility is likely to impact your investments – and since human nature focuses on avoiding losses over achieving gains – fluctuations in your portfolio can be hard to ignore. During these stressful times, it’s important to be a rational investor and temper emotions – because investing on emotions carries a few risks.
Buying high and selling low
One of the biggest challenges for investors is that they tend to get caught up in market swings and lose sight of the big picture. When the stock market is doing well, investors are in a rush to buy. And when the market takes a tumble, people panic and sell. This unintentional strategy of buying high and selling low completely undermines the investor’s original plan.
From 1994 to 2013, stocks had an average return of 9.2% per year and bonds had an average return of 5.7%. The average investor: 2.5%. Of course this gap can’t solely be attributed to emotional-missteps, but there’s enough research on the subject to warrant a closer look. For example, the Odd Lot theory is a market indicator which says that the small or individual investor is always wrong. So if sales of a stock increase in odd-lots (which are typically an indication of small investor activity) then subscribers of this theory think it might actually be a good time to buy.
Confidence is also an emotional response that can carry risks. If investors get overconfident about their abilities, especially if they’ve had some good results, it can adversely impact decision making later on. Overconfident investors might hold onto to a losing stock too long and take further losses because they don’t want to admit that they made an investment that didn’t pan out. Emotional attachments to a particular stock can also occur, which prevents investors from selling or diversifying when appropriate.
Overconfident investors often try to time the market in search of a better return. Not only is this very difficult to do, even for the most seasoned asset management professionals, but excessive trading has consequences of its own. Higher trading fees cut into returns and continually recognizing capital gains can also carry (potentially unanticipated) tax implications.
When you begin to invest, it is advisable to determine an asset allocation strategy that is consistent with your financial goals and risk preferences. Constructing a portfolio using a mix of different assets classes based on these goals and preferences allows investors to diversify without compromising the expected returns of the underlying portfolio.
Investors who make emotional decisions often end up accidentally changing their underlying asset allocation due to current market conditions. For example, if stocks are rallying an emotional investor may sell some of his bond positions and use the proceeds to invest in additional stocks. This change effectively unbalances a portfolio and could lead to a person taking on more risk than they’re comfortable with or is necessary based on their objectives.
There are a few strategies that can help you control your emotions:
Stock checking. Try to limit how often you check on your investments. While reviewing your portfolio at set intervals during the year is important, obsessive checking can cause panic.
Keep your end-game in mind. Goal-based investing is an effective strategy to reduce emotional decisions. Here, instead of focusing on market index returns, investors track portfolio performance against their progress towards meeting stated objectives. With proper diversification and asset allocation, even in an economic downturn, many investors could still be on track to meet financial goals, such as retiring in 15 years with their desired nest egg.
Seek professional help. Working with an investment advisor can also help curb the effects of emotional investing. Having a trusted fiduciary manage your assets can help ensure you’re in the proper asset classes for your risk tolerance, and manage your portfolio to help you stay there. Investors may be more likely to stick to a strategy outlined by a professional instead of second-guessing their choices as a do-it-yourself asset manager.
While it can be hard to remember that the market fluctuations are part of investing if you see an adverse impact on your bottom line, having a strategy in place and the support of a trusted advisor can help you stay the course.
Financial Planning Association of Massachusetts member Kristin McFarland is the Director of Strategic Partnerships with The Darrow Company in Boston. The Darrow Company is a fee-only asset management and financial advisory firm focused on building and preserving the wealth for their diverse client base.
Kristin McFarland is an investment adviser representative of The Darrow Company, Inc., an SEC registered investment adviser located in Massachusetts. The material contained in this article is for general information only and should not be construed as the rendering of personalized investment, legal, accounting, or tax advice.
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