One of the biggest challenges when it comes to investing is keeping emotions out of your investment decisions. This has become harder than ever in today’s media-saturated, social media-centric world — where every market movement and economic development is scrutinized and analyzed by supposed experts who may or may not know what they are talking about.
Continue Reading Below
History has clearly shown that the investment markets are volatile. They can rise or fall sharply from week to week, or even day to day, for no apparent reason - at least that is how it seems to average investors who do not closely follow the intricacies of the markets as the pros do. Those who are too caught up in these wild market swings can end up making investment decisions based more on emotions than facts.
Cycle of Emotional Investing
Emotional investing often follows a well-worn cycle. In bull markets like the one we are currently experiencing, the cycle starts with extreme optimism. Emotional investors believe that the markets only move in one direction — up — so they invest money giddily and watch their portfolios grow month after month. Sometimes, they chase after the latest stock market tips or rumors, hoping to hit upon a big score.
In a long-running bull market, emotional investors can become blind to the risks that are inherent in investing, especially stock market investing. They sometimes think that we have entered a “new normal” in which the old rules no longer apply and market corrections are a thing of the past. This is the point where emotional investors are often at the greatest risk, because there is no such thing as a new normal when it comes to investing – eventually the same old patterns will emerge.
When the markets experience a correction or severe downturn, emotional investors often become fearful and anxious. The fear of financial loss can be a stronger emotion than the excitement of financial gain, so emotional investors tend to panic when markets start to turn and question the investment decisions they previously made.
If the market correction or downturn is prolonged, many emotional investors eventually decide to throw in the towel and sell their investments, usually at a loss. In doing so, they break the simplest investing rule in the book: Buy low and sell high. Instead, they end up doing the opposite, having bought investments when they were at their peak and sold them at or near their trough.
The ironic part of this cycle is that if they had just been able to hold on, many emotional investors would have seen their investments rebound from the trough and start rising again. For example, when the Dow Jones Industrial Average fell from almost 16,000 in the fall of 2007 to just below 8,000 in early 2009, many emotional investors decided that they could not stomach the losses any longer and sold. Those who did missed one of the greatest bull market runs in history, as the Dow has risen all the way to nearly 18,000 since bottoming out about six years ago.
Do’s and Don’ts for Emotional Investors
An important key to sustained investing success is making investment decisions with your head, rather than your heart. Here are six investing “do’s” and “don’ts” to help you accomplish this:
1. Do tune out the daily ups and downs of the markets. This is probably the hardest rule for many investors to follow, but it is also one of the most important. It seems like almost everywhere you look, there is a stock market ticker providing up-to-the-minute quotes of the Dow, the S&P 500 and the NASDAQ, not to mention 24/7 cable TV channels devoted to discussing the latest market moves. Try to ignore these as much as you can.
2. Don’t celebrate unrealized profits, or mourn unrealized losses. It is important to remember that you have not actually gained or lost any money with an investment until you have sold it. So if your portfolio statement shows that you have “made” or “lost” a certain amount of money over the past month, do not get too excited or discouraged by this. Such gains and losses are only on paper until you have liquidated the investments.
3. Do maintain a long-term investing timeframe. In most situations, investing is a long-term play. While there are some scenarios where you might invest for short-term goals, like a down payment to buy a home in a couple of years, most investing strategies are long-term in nature, like paying for college or funding your retirement. When you keep your focus on the long term, it makes it emotionally easier to ride out short-term market volatility.
4. Don’t follow the investing crowd. It can be easy for emotional investors to adopt a “follow the herd” mentality. They think that if everybody else seems to be buying or selling, then this is probably what they should do. However, the crowd thinking tends to be largely based on irrational biases, so following the herd might lead you right off the edge of the investing cliff.
5. Do implement dollar-cost averaging. Once you adopt a long-term investing perspective, you can put dollar-cost averaging to work. With this strategy, you invest a fixed amount of money every month, regardless of what the markets are doing. As a result, you end up buying more shares when prices drop and fewer shares when prices rise. Over time, this tends to smooth out market volatility and take emotions out of investment decisions.
6. Don’t try to time the markets. History has proven over and over that trying to time the markets by actively buying and selling investments to try to earn short-term profits is a foolhardy strategy for most investors. The day-trading craze of the late 1990s was based on short-term market timing, and many day traders suffered huge losses due to their inability to make the right calls — and to avoid getting emotionally, as well as financially, invested.
If you struggle with emotions when making investment decisions, you are not alone. We are all human, and it is easy to get emotional about our money — especially when it comes to losing it. By remembering these investing do’s and don’ts, you will take a big step toward keeping emotions out of your investing decisions.