The old cartoon character Pogo famously commented: “We have met the enemy and he is us.”
Pogo could well have been describing an investor trying to navigate today’s markets. We can be our own worst enemy with our emotions betraying sound advice at any moment.
One of the most valuable lessons you can learn in investing is to beware of your emotions.
Feelings like fear, euphoria, or greed act as powerful unseen motivators. A behavioral finance paper stated that financial gains trigger the same “reward circuitry” in the brain as cocaine, while financial losses trigger a hard-wired “fight-or-flight” response.1
Various emotional states can sabotage your investing behavior and hard-worked, long-term financial plan. These common investing emotions lead to mistakes:
- Euphoria. The delight of seeing your stocks go up day after day makes success seem self-perpetuating. An investor can catch the “bubble” mentality of the crowd.
- Fear. When an ugly day (or week or month) brings falling market prices, an investor can be tempted to sell everything and “go to cash,” possibly missing an opportunity as the market rebounds.
- Overconfidence. In a rising market, an investor may believe his or her own superior abilities are causing the gains. It is easy to ignore warning signs or the need for caution.
- Hyperactivity. Bombarded constantly with real-time information, an investor can react to every twist and turn in the market. Tinkering is costly and distracts from the long-term plan.
- Denial. An investor watching an asset drop in price may be reluctant to sell and recognize a loss. Selling a depreciated asset goes against an emotional tendency not to admit failure.
- Greed. In any market, the allure of “more” can entice an investor to seek more yield on a bond, more growth in a stock. But beware — the promise of more return also means more risk.
Follow your plan.
Discipline can be the antidote to the emotions that drive your investing astray. Following a well-designed investment plan will keep you on track to achieve long-term financial goals. Some pointers on avoiding the emotional tug of war in investing:
- Have a specific plan. Most investors follow a strategy in their head that is highly changeable. A more structured plan — spelling out long-term goals, approaches to risk and return, and strategies to achieve those goals — will serve as a steady guide.
- Track progress on a schedule. Obsessing over investments daily or moment to moment is counterproductive because of the temptation to make frequent changes. Reviewing your portfolio regularly but not too frequently and meeting with your financial advisor at least twice a year will help separate you emotionally from the swings of the market.
- Talk with an investment advisor. An experienced financial professional can offer you perspective on the fluctuations of the market. Investment advisors acting as fiduciaries can offer objectivity and commitment to your best interests, giving you an anchor against the emotional winds of the market and sensational media coverage.
- Learn how to sit still. Be aware that volatile markets make it hard to do nothing. If the stock market drops today, the temptation is to sell stocks, buy, or react in some way. But responding to every market fluctuation is focusing on the small picture. Practice the habit of focusing on the larger picture, which includes your financial goals and long-term strategies.
Benefits of discipline.
Changing your investment positions based on emotions can be costly and counterproductive. The frequent activity of a reactive investor tends to run up commissions and other transaction costs. If you invest by feelings, your tendency may be to do the wrong thing at the wrong time — sell out of fear when prices are down, or buy out of greed when others have driven prices up.
Instead, a smart investor works on the habits of disciplined investing: following a structured plan, tracking progress, getting objective advice, emphasizing asset allocation, and — more often than not — knowing the value of doing nothing at all.
What to do next.
- Give yourself a checkup on the common emotions that lead to investing mistakes.
- Put your energy into designing and following a sound long-term investment plan.
- Review your portfolio regularly and talk with your financial advisor as your personal situation changes.
- When the market threatens to change your investment positions based on emotions, talk to an experienced professional investment advisor.
1 Lo, Andrew. (August 28, 2011). Fear, Greed, and Financial Crises: A Cognitive Neurosciences Perspective. Retrieved October 4, 2017, from http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.360.3908&rep=rep1&type=pdf