You wouldn’t be human if you didn’t fear loss.
Nobel Prize–winning psychologist Daniel Kahneman demonstrated fighting fear with facts with his loss-aversion theory, showing that people feel the pain of losing money more than they enjoy gains. As such, investors’ natural instinct is to flee the market when it starts to plummet, just as greed prompts us to jump back in when stocks are skyrocketing. Both can have negative impacts.
But smart investing can overcome the power of emotion by focusing on relevant research, solid data and proven strategies. Here are seven principles that can help fight the urge to make emotional decisions in times of market turmoil.
What is Emotional Investing?
Emotional investing refers to the tendency of investors to make financial decisions based on feelings rather than facts. It occurs when emotions such as fear, greed, excitement, or anxiety override logical analysis and rational decision-making in investment choices. While it’s natural for emotions to play a role in our financial lives, allowing them to dictate investment strategies can often lead to poor outcomes and missed opportunities.
The Psychology Behind Emotional Investing
Human psychology plays a significant role in how we approach investing. Several cognitive biases and emotional responses can influence our financial decisions:
- Fear of Loss: As mentioned in the original article, loss aversion is a powerful force. The pain of losing money often feels more intense than the pleasure of gaining an equivalent amount, leading investors to make overly conservative choices or panic-sell during market downturns.
- Herd Mentality: The tendency to follow the crowd can lead investors to buy when markets are high (out of fear of missing out) and sell when markets are low (due to panic), often resulting in buying high and selling low – the opposite of a successful investment strategy.
- Overconfidence: Some investors overestimate their ability to predict market movements or pick winning stocks, leading to excessive trading or concentrated positions that increase risk.
- Recency Bias: Giving too much weight to recent events and assuming they will continue into the future can cause investors to chase performance, buying into asset classes or sectors that have recently performed well but may be due for a correction.
- Confirmation Bias: The tendency to seek out information that confirms our pre-existing beliefs while ignoring contradictory evidence can lead to poor investment decisions based on incomplete or biased information.
5 Common Emotional Investing Traps
Understanding the common pitfalls of emotional investing can help investors recognize and avoid them:
- Panic Selling: Selling investments hastily during market downturns, locking in losses and missing out on potential recoveries.
- Performance Chasing: Investing heavily in assets or funds that have recently performed well, often just as they’re about to underperform.
- Market Timing: Attempting to predict the best times to enter or exit the market, which is notoriously difficult and often leads to missed opportunities.
- Holding Losers Too Long: Refusing to sell underperforming investments due to an emotional attachment or the hope that they’ll recover.
- Overtrading: Excessive buying and selling based on short-term market movements or news, which can increase costs and reduce long-term returns.
7 Principles to Help You Avoid Emotional Investing
1. Market declines are part of investing
Stocks have risen steadily for nearly a decade, but history tells us that stock market declines are an inevitable part of investing. The good news is that corrections (defined as a 10% or more decline), bear markets (an extended 20% or more decline) and other challenging patches haven’t lasted forever.
The Standard & Poor’s 500 Composite Index has typically dipped at least 10% about once a year, and 20% or more about every four years, according to data from 1949 to 2018. While past results are not predictive of future results, each downturn has been followed by a recovery and a new market high.
2. Time in the market matters, not market timing
No one can accurately predict short-term market moves, and investors who sit on the sidelines risk losing out on periods of meaningful price appreciation that follow market downturns.
Every S&P 500 decline of 15% or more, from 1929 through 2018, has been followed by a recovery. The average return in the first year after each of these market declines was nearly 55%.
Even missing out on just a few trading days can take a toll. A hypothetical investment of $1,000 in the S&P 500 made in 2009 would have grown to more than $2,700 by the end of 2018. But if an investor missed just the 10 best trading days during that period, he or she would have ended up with 38% less.
3. Emotional investing can be hazardous
Daniel Kahneman won his Nobel Prize in 2002 for his work in behavioral economics, a field that investigates how individuals make financial decisions. A key finding of behavioral economists is that people often act irrationally when making such choices.
Emotional reactions to market events are perfectly normal. Investors should expect to feel nervous when markets decline, but it’s the actions taken during such periods that can mean the difference between investment success and shortfall.
One way to encourage rational investment decision-making is to understand the fundamentals of behavioral economics. Understanding behaviors like anchoring, confirmation bias and availability bias may help investors identify potential mistakes before they make them.
4. Make a plan and stick to it
Creating and adhering to a thoughtfully constructed investment plan is another way to avoid making short-sighted investment decisions — particularly when markets move lower. The plan should take into account a number of factors, including risk tolerance and short- and long-term goals.
One way to avoid futile attempts to time the market is with dollar cost averaging, where a fixed amount of money is invested at regular intervals, regardless of market ups and downs. This approach creates a strategy in which more shares are purchased at lower prices and fewer shares are purchased at higher prices. Over time investors pay less, on average, per share. Regular investing does not ensure a profit or protect against loss. Investors should consider their willingness to keep investing when share prices are declining.
Retirement plans, to which investors make automatic contributions with every paycheck, are a prime example of dollar cost averaging.
5. Diversification matters
A diversified portfolio doesn’t guarantee profits or provide assurances that investments won’t decline in value, but it does lower risk. By spreading investments across a variety of asset classes, investors lower the probability of volatility in their portfolios. Overall returns won’t reach the highest highs of any single investment – but they won’t hit the lowest lows either.
For investors who want to avoid some of the stress of down markets, diversification can help lower volatility.
6. Fixed income can help bring balance
Stocks are important building blocks of a diversified portfolio, but bonds can provide an essential counterbalance. That’s because bonds typically have low correlation to the stock market, meaning that they have tended to zig when the stock market zags.
What’s more, bonds with a low equity correlation can offer protection from losses even when the broader market is in turmoil. Funds providing this diversification can help create durable portfolios, and investors should seek bond funds with strong track records of positive returns through a variety of markets.
Though bonds may not be able to match stocks’ growth potential, they have often shown resilience in past equity market declines. For example, U.S. core bonds were flat or positive in five of the last six corrections.
7. The market tends to reward long-term investors
It’s always important to maintain a long-term perspective, but especially when markets are declining. Although stocks rise and fall in the short term, they’ve tended to reward investors over longer periods of time. Even including downturns, the S&P 500’s average annual return over all 10-year periods from 1937 to 2018 was 10.43%.
It’s natural for emotions to bubble up during periods of market volatility. Those investors who can tune out the news and focus on their long-term goals are better positioned to plot out a wise investment strategy.
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