Controlling emotions is critical when it comes to investing and building wealth. Anyone who invests has likely felt the thrill of seeing a stock purchase quickly skyrocket in value as well as the panic the sets in when a different or that same investment financially tumbles due to unforeseen circumstances. When your own hard-earned money is on the line, emotions can often dictate investment decisions and result in losses (and the more than likely recovery in that investment) that could have been avoided.
In a perfect investment world and when it comes to building wealth per financial literacy, the plan is to buy low and sell high to maximize profits. However, historical trends show emotion-driven investing has resulted in the opposite result and leads to poor performance. For example, in the 2008 financial crisis, many people rushed to liquidate investments as the market bottomed out and lost money on the eventual recovery their original investment as a result. Had those investors not panicked and left their investments alone, in most cases those stock as well as bond investments would have again been generating substantial earnings within a few years.
Between 1997 and 2016, the average investor gained about 4% annually on investments while the S&P 500 saw an annualized return of about 10% per data from Standards and Poors as well as financial advisers. This suggests that continuous tinkering with investment portfolios based on emotion caused investors to earn far less over the long-term than would have been earned if the investments were left unchanged. Eliminating emotions from investment decision is an important financial literacy skill to have. As controlling your emotions/feelings will, in almost all situations, improve long-term financial gains.
Strategies to Minimize Emotional Investing
Controlling your emotions when it comes to financial decisions can be difficult. While there may be no perfect approach, there are steps that can be taken to keep your emotions in check and reduce the risk of making poor decisions. These steps can help you buy when stocks or bonds are “lower” and sell when they are “higher”.
Clarify your long-term financial goals. Always keep the focus on the long term objectives of your investing and set realistic goals as part of personal financial literacy. If your investment goal is to accumulate a specific amount for retirement in 25 years, accept the fact that there will be peaks and valleys along the way. Looking at the big picture and what you hope to accomplish over many years should help to avoid emotional decisions based on daily fluctuations in the market.
Know that long term investing is how you build the most assets and wealth over time. Remember compound annual returns, the Rule of 72, dollar cost averaging and more. If you sell do to your emotions when investments are low (and buy when they are higher) that is a horrible strategy. Read about compound annual returns from long term investing.
Determine your risk tolerance. All investments have risks whether they involve the purchase of stocks, bonds, real estate or business ventures. Understanding your risk tolerance when you begin investing can help to avoid emotional decision-making in the future.
You don’t need to sink money into the riskiest investments available to achieve success. As those are often volatile, and emotions can be hard to control in those cases. If you are risk-averse, choose safer investments when you first begin investing. Once you have accumulated some earnings and feel more comfortable, move some of your funds into slightly riskier alternatives.
Don’t be afraid of losing. Seeing investments lose value at times is part of investing. If you are constantly afraid of losing money, you will never take legitimate risks to truly make your money grow. Successful investing requires taking some level of risk and having the fortitude to avoid dumping an investment at the first sign of value loss.
Diversify and re-balance. Don’t put all your eggs into one basket. In the investing world, that means don’t simply buy one specific stock or create a portfolio that includes just stocks or just bonds. Or don’t buy equities that are all in similar industries or business lines. Having a portfolio that includes investments of varying risks will reduce the potential for making bad or emotional decisions when one type of security falters.
A diverse portfolio may include stocks, bonds, treasury notes, precious metals, cash, index or mutual funds and even real estate. Diversifying also means investing in a variety of industries and regions. Rarely will all types of securities follow either an upward or downward trend at the same time. The diversification in itself can help prevent you from making emotional sell decisions during a crisis or panic. A well-diversified portfolio should allow some types of investments to offset losses in others over the long term.
In a down market, re-balancing your portfolio rather than selling off large pieces of it may prove a wiser move. Converting some stock into bonds, Treasury bills or index funds for a short period can prove to be valuable when the stock market becomes volatile.
Making small changes is often more advantageous in the long-term compared to initiating an extreme makeover of a portfolio. For example, if the market is on a downward trend, converting 25% of your stock investments into less risky securities may be more beneficial than selling off 100%. Do that is you feel an “emotional; panic”, that way you are at least doing something while not destroying your portfolio. If the trend reverses you haven’t sold everything and can benefit from the rebound, but if the downward trend continues you will have at least removed some of your funds from being negatively affected.
Create a method and follow it. Create a system for investing and establish objective criteria that must be met to buy or sell any specific investment. Barring a major upheaval in financial markets, follow your plan to the letter as part of your financial literacy plan. Following an established formula should eliminate emotional decisions. If the prospective investment falls within your set guidelines, you buy it. If not, you pass and don’t give the decision another thought.
Dollar Cost Averaging involves investing on a recurring, consistent basis. You invest the same amount of money when markets go up or when they go down. It takes the emotion out of investing as it is done automatically, on so called auto-pilot. In fact, it is a great approach when markets or more volatile as you may be more stocks or other investments at a lower dollar amount. Remove the emotions from investing, and find how dollar cost averaging can do that.
Don’t be guided by the nightly news, forums, or social networks. Basing investment decisions on the day’s headlines usually suggests decisions are being driven by emotion rather than deliberate, rational reasoning. Reacting to news stories or feedback from others often results in making uninformed decisions that ultimately prevent investments from growing in value. Never simply assume that your investment will be impacted by a given news event. Successful investing requires doing research and seeking input from a variety of sources. The social media news feeds, Cable TV talking heads, or evening news report should just be one of many ingredients on which your investment decision relies.
Don’t become personally attached to investments. Keeping a stock simply because it was originally a gift from someone special or may involve a company you have loved for years makes little sense when the stock starts underperforming. Having an emotional attachment to an investment makes it difficult to accept the logic of selling when the market dictates. The result may be a lost opportunity to purchase another stock on the upswing or incurring a financial loss that could have been avoided. Keeping stock simply because you are emotionally attached to it is like betting on a horse at the track simply because you like the horse’s name. It may feel good, but it makes little sense.
Consult a financial advisor or investment professional. One of the best investments you can make is retaining an experienced financial advisor or a third party who can give you some thoughtful advice. Even use FINRA to find a broker. Once you and your advisor have established an investing strategy, the advisor can play a valuable role to keep you on track and help you control your emotions. Being able to turn to a professional who evaluates and makes investment decisions daily can help to put news events in perspective by sorting out rumors and addressing your concerns. A personal advisor can also help guard against making or keeping investments based on emotional attachment.
A good advisor will not wait for you to call when a major event shakes up the market. The advisor should take the time to clearly explain why any investment is being recommended and how your portfolio provides financial safety even if markets turn volatile. If re-balancing your portfolio is recommended, the advisor should describe how this will occur and the advantages that will result.
While dispensing advice by e-mail, chats, videoconferencing and phone works much of the time, the ability to meet with your advisor face-to-face on occasion can go a long way to provide the reassurance necessary to keep emotions in check and avoid making poor investment choices. If you are not feeling reassured by your advisor, that’s a sign that you need to find a new investment professional. Having trust in the person making decisions about your money is essential. Find a registered investment advisor from FINRA.
If you can’t afford or choose not to retain a financial advisor, at least consult with someone you trust for a second opinion before making significant investment decisions. A friend, partner, spouse, peer, co-worker, or anyone. We even have a free online forum for investing advice. Acknowledging that a specific event has triggered your emotions is fine. The goal is to avoid acting impulsively. Taking the time to talk with an advisor or trusted friend can help you to put things in perspective, re-evaluate your investing approach and avoid making rash decisions.
Successful Investing Means Controlling Emotions
A good investment strategy is one that eliminates the emotional component to investing (especially for long term needs) as much as possible. The strategy should be built to reach your goals while matching your tolerance to handle risk. Investors need to decide what will work best for their specific circumstances and needs. In investing, as in many endeavors, patience as well as not being overtly emotional is a virtue. Having a well thought out investment strategy and avoiding panic during periods of market volatility will usually combine to deliver the best long-term financial result.
By Jon McNamara