Understanding emotional investing

Making investment decisions solely based on emotions often ends in disaster. In the ever-changing world of the stock market with all the market fluctuations, it’s no surprise that an average investor finds it hard to keep his emotions in check. Sometimes they overpower us, but mostly we let them. These result in poor investment decisions which affect your financial goals and most importantly, your returns.

The worst decisions in investing are the ones that are driven by emotions. It clouds your judgment, makes you ignore all the rational aspects and the possible outcomes, and you end up losing a lot of money.

Take this for example; Between 1997 and 2016, average stock market investors earned only 3.98% returns annually, compared to the S&P 500 index’s 10.16% annual returns. Why? They let their emotions take over and made illogical, bad short-term investing decisions to buy or sell more stocks, looking to gain profit or save money, and lose out on capital gains in the long term.

What triggers these emotions?

a man affected by emotional investing

Emotional triggers, as I would like to call them, can come in many different forms. Fear of missing out (FOMO), plays a major role in most of these. Especially when it comes to market volatility, the mainstream media seems to sensationalize any ‘worthy’ news it gets. This media hype often leads investors to make investment decisions without thinking too much.

By following the ‘now-or-never news, they buy more stocks, often overpriced, looking to make more profits with their investment portfolio in a bull market. Whereas in a bear market, they start selling stocks to minimize losses and mitigate risks, cashing out the stocks, and then look for less-risk options like savings products. As both of these can be emotionally overwhelming times(greed and panic), people tend to react to any news that, either present an opportunity or confirm what they are already thinking about.

Social media is another trigger. Since these platforms figure out our interests and likes faster than our friends, investors will likely come across ‘investment advice’ on these platforms. Most people who give out ‘advice’ on these platforms have experience ranging from 1-2 years at the most. Since they are presented and communicated in the best way possible, most of us fall prey to this. After all. who doesn’t like to know the ‘top 10 stocks to buy under $50 for 2021’.

It’s important to understand that the market itself is the biggest trigger. With ups and downs happening constantly, the volatile nature of the market can be worrying for many.  For an average investor, their hard-earned money is at stake, so naturally, their risk tolerance would be very low. Because, let’s face it, losing money is painful. So this constant fear about the investment performance can be stressful. As humans, we tend to act based on emotions more, when we are under a lot of stress, and that often leads to making decisions without rational and reasonable thought, which most of the time, makes the situation worse.

How to avoid emotional investing?

We, humans, are creatures of emotion, no doubt about that. Every decision we make involves some amount of emotion, or else we wouldn’t be able to make any. However, it’s important to have a clear distinction between having emotions and being driven by them.

In the ever-changing world of the financial market, it can be hard to keep your emotions in check. But there are a couple of things that you can do to channel your emotions for your benefit.

Have an investment plan

open diary and a pencil

As the saying goes, ‘Hope for the best and plan for the worst, it’s crucial to have an investment strategy that clearly aligns with your long-term goals and financial capabilities. When the times are favorable, instead of only looking to make maximum profits, make sure every decision you make aligns with your investment objectives. Also, when times are tough, and the emotions overwhelm you, it’s important to have something you can stick to. Understand that market volatility doesn’t usually last, and if you buy or sell according to the ‘trend’ of the market, you will lose money in the long run. So have a plan, write down your goals, and stick to it, all the time.

Educate yourself

Understand that market risk exists. Know that you will come across market corrections and bear markets during the course of your life as an investor. Market corrections are a drop of 10% or more from a recent market high, whereas bear markets are usually defined as a decline of 20% or greater. Since 1950, there have been 36 corrections in the S&P 500 and there have been 26 bear markets in the S&P 500 Index since 1928. Despite that, S&P 500 has had an average annual return of 10-11 % since its inception in 1926 through 2018. How?

Because there have also been 27 bull markets, and stocks have risen significantly over the long term. When it comes to market corrections, on average, within four months after a correction, S&P 500 reaches its pre-correction peak – roughly the same amount of time to recover as the initial decline took.

So it is quite important to educate yourselves on the various aspects of the market cycles, including the reasons behind a market crash/correction or a bear market. Knowing these will help you in staying away from all the noise during the good and bad times, and to keep your head straight, even when everyone around you is losing theirs.

Use media as a tool

I can’t emphasize how important it is.

Media is a tool, not your financial advisor.

Like all tools, if you don’t use it carefully, it can bring damage. Don’t get me wrong, it is important to be updated on what is going in the market, but the headlines shouldn’t determine your investment strategy. It is easy to get caught up in the over-hyped news, whether it is a bull or bear market. But making investment decisions based on the news you hear, without rational thought, you ignore factors like the long-term effects or other business and economic contexts. You might feel like you are acting based on your ‘instinct’ when in reality you are jeopardizing your investment objectives in an emotional gut response.

Take the time to go through the news, and when making a decision ask yourselves, “does this align with my investment goals?”If not, it probably isn’t worth it, and always, I repeat – always, see the bigger picture.

Additional measures:

 

Stop checking your investments every day

This might sound silly, but it’s a good way of ensuring that you’re not affected by the short-term volatility that is frequent in the market. Then again, after a couple of years as an investor, you’ll start doing this yourself.

Ditch the herd mentality

It’s the innate characteristic of a human mind to follow the crowd, but let’s not do that here. Consider GameStop for an example; when everyone is talking about it and buying it, you might have the urge to do the same. By doing so, you’re acting based on societal perception rather than your own research. And when it works against you, you’ll blame yourself.

Use a long term investment strategy

There is an old saying, “time in the market beats timing the market”. So instead of trying to time the market, use these long-term investment strategies that not only will ensure you don’t make any spontaneous emotional decision, at the same time this will help you sleep in peace at night, even during the worst of times.

  1. Diversification: Diversifying is when you invest across different asset classes(stocks, bonds, funds), different industries, or different geographies. This asset allocation offers protection against the volatility of the market. Since it’s highly unlikely that all markets will go down at the same time, the less-performing assets will be balanced by gains from others.
  2. Dollar-cost averaging: It is a strategy where equal amounts of dollars are invested at a regular, predetermined interval. The key to its success is sticking with the plan. This will ensure that you are not carried away every time you see ‘breaking news. Set the plan and don’t interfere with it, unless major changes are required.

Journaling your ideas

Every time you see a stock you’re interested in owning, write it down for further research. Use this logbook to perform efficient research that will help you value the company and understand whether it’s worth investing in or not. The video below explains how to use the logbook.

Get the free digital versions of the logbook here and the spreadsheet here. If you would like to have a physical copy, as I do, you can get it here.