Average investors have underperformed the stock market for the past 20 years and they have their emotions to blame.
Instead of buying low and selling high, the basic rule of investing, individual investors often let their emotions take over and do the opposite.
“Humans are hardwired to go toward anything that makes us feel good and run away from anything that may hurt,” says Chris Cook, a portfolio manager, president and founder of Zero Commission Portfolios. “When the market is running up, if you spend any time in a brokerage house you will see the phones are ringing off the hook from clients that want to get in the market.” When the markets are tanking, those same investors are looking to get out, he says.
When it comes to investing, emotions run high: No one wants to lose the funds they are banking on for their future. Because of that, many investors spend hours checking stock prices, reading headlines and moving their investments and changing 401(k) allocations in reaction. But money managers say the biggest mistake investors can make is reacting to those gyrations in the stock market. While there are exceptions like the 2008 market crash, experts say investors are better served if they come up with a strategy, and stick with it for the long term.
“The only real defense against trading emotions is just sticking to a plan and doing the same thing all the time,” says Kevin Luss, founder and president of the Luss Group. “If you pick stocks based on investors’ principles…clients are more apt to ride out the storm.”
He stresses making sound investments from the start which requires due diligence or advice from a professional. Investors need to be honest about the amount of risk they can handle and help curb desires to react on emotions--both negative and positive.
Ultimately, Luss says investors have to realize markets are cyclical and will move up and down on any given day. “The market is at its peak right now and people are dumping a lot of money into it even though there’s the most amount of risk.”
Before making any investments, money managers recommend investors establish a set of strict rules on how to manage the portfolio in terms of when to buy and sell and when to rebalance. “The reason why the S&P 500 beats the vast majority of professional managers year in and year out is there’s a simple set of rules and it never deviates,” says Cook.
Cook says everyone needs to have a protection plan for when investments aren’t working. That plan may call for a stock to be sold off if it declines 10% or for the investment to shift to bonds if the stock market tanks a certain percentage. Whatever the protection plan , having one will alleviate some of the fear and reduce the urge to act.
Reacting to news is another mistake many investors make and is a common reason people end up buying high and selling low. By the time the information hits the media, institutional and more sophisticated investors have already reacted. “The markets are very, very efficient,” says Luss. “By the time any news is in the newspaper its long been absorbed into the market.”