Understanding the Emotions of Investing

No one can control the stock market or exactly how an investment will perform. And that lack of control can lead to making poor (and many times, emotional) investing decisions – like chasing performance, not diversifying, or moving into and out of the market (often at the wrong time).

While these reactions can be triggered by a desire to avoid risks, the results of these behaviors can pose the greatest risk of all -- not reaching your long-term goals. In fact, the biggest risk may not be market fluctuations themselves; it's our reaction to these fluctuations. That's why it's so important to have a financial advisor in your corner, helping you stay committed to your investment strategy.

Here are some common emotional investing behaviors that may derail your journey to reaching your long-term goals. By understanding the pitfalls of these behaviors, you can prevent making these mistakes in the future.

1. Heading to (or staying on) the sidelines

stay-invested

Source: Copyright © 2014 Ned Davis Research, Inc. All rights reserved. Total return includes dividends. These calculations do not include any commissions or transaction fees that an investor may have incurred. If these were included, it would have a negative impact on the return. The S&P 500 is an unmanaged index and cannot be invested in directly. Past performance does not assure future results.

We've all seen the headlines: the economy's slow recovery, the government's budget deficit, market fluctuations. Prompted by what they perceive as bad news, some investors may try to "time the market" or sell investments just because of what they hear in the news – to move to the sidelines and wait until things get better. But it's nearly impossible to correctly predict when to get out and even more difficult to decide when to get back in, which often results in missing the best days – thereby severely affecting your performance And often, waiting until things get better means selling when prices are down and then buying back in when prices are higher – not a recipe for long-term success. 

Other investors hold in too much cash because they want to avoid market risk. But not investing could actually increase your risk because you may not have enough growth in your portfolio to meet your goals or offset inflation.

2. How to stay in the game

Keep your focus on your long-term goals rather than on the ever-changing headlines, which could focus too much on the negative for dramatic effect. 

how-to-stay-in-the-game

BusinessWeek cover used with permission of Bloomberg L.P. Copyright © 2013. All rights reserved. Time Magazine, January 10, 1983. © 1983, Time, Inc. Used under license. Time Magazine and Time Inc. are not affiliated with, and do not endorse products of services of, Edward Jones.

If you begin to feel overwhelmed, talk with your financial advisor about your attitude toward risk and observe how you react to specific events. That way, you can work together to refine your goals and investment strategy, if needed.

3. Chasing performance

When the media raves about the latest "hot" investment or highlights "dramatic" declines in the market, some investors are tempted to chase the winners and sell the losers. This type of emotional response could be a recipe for underperformance because it results in buying high and selling low – not the recipe for a successful investment strategy.

chasing-winners-selling-losers-1
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Source: Morningstar. Past performance is not a guarantee of future results.

4. How to stay diversified

how-to-stay-diversified

Sources: Bloomberg and Morningstar. Past performance is not a guarantee of future results. An index in not managed and is unavailable for direct investment. Rounded to the nearest $5,000.

Having a diversified set of investments is more important than trying to find the next "hot" investment. When you have a portfolio made up of a variety of quality asset classes and investment types, success isn’t tied to one company or one type of investment. While diversification cannot guarantee a profit or protect against loss, it can help smooth out the ups and downs of the markets, providing the potential for a better long-term experience.

We recommend reviewing your portfolio with your financial advisor at least once a year to ensure it's adequately diversified. Your financial advisor can also help you decide if a recent major lifestyle or goal change warrants a change to your strategy.

5. Focusing on the short term

Day-to-day fluctuations in an investment's value may tempt some investors away from their long-term strategy. For example, some investors sold out in 2008 because their portfolio had fallen from an all-time high, even though their performance may still have been on track to meet their goals and well above where they initially started.

Decisions can also be influenced by how a situation is presented. 

Take this example: "The Dow plummets 150 points" OR "the Dow declines 1%." Both could describe the same situation, but the first sounds much worse. It's these short-term movements, and how they're presented by the media, that could lead you to make emotional short-term decisions.

6. Setting Realistic Expectations

Realizing that market declines, while unpleasant, are normal will help you set your own realistic expectations for investment performance. After all, the stock market averages one 10% correction every year, and over a 25-year retirement, you could experience an average of six to seven bear markets.

It's important to measure performance as progress toward your long-term goals, not in day-to-day fluctuations. Your financial advisor can help you answer the question, "How am I doing?" and help provide the discipline you’ll need to stock with your long-term strategy and ignore short-term distractions.

How we can help

So when you feel your emotions beginning to get the better of you, take a "timeout" and work with your financial advisor to review your goals before making what could be an emotional investing decision. Your portfolio and your future self will thank you.

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