Whether you’re new to investing, or seasoned with experience, it’s difficult to keep your emotions in check as you make your way through the daily news. Missed earnings here, failed product launch there, your first instinct may likely be to sell your shares in company XYZ. Yes, their stock may drop in the following days or weeks, but when it comes to the stock market - it’s important to think long term.
Selling your investments now based on an emotional response could mean missing out on significant earnings months / years / decades down the line. Before you risk that chance, use these four easy strategies to help avoid investing with your emotions.
4 Strategies to Reduce Emotional Investing
Need help reducing your emotional investing? We've got some helpful tips below.
Strategy 1: Find a Behavior Coach
Working with a financial advisor can be your first line of defense against behavioral investing. Some investment advisors or financial planners have experience in coaching and education around behaviors, such as common cognitive biases.
Cognitive biases are the result of subjective social reality derived from personal perceptions and typically deviate away from rationality in judgment. In other words, these biases may result in irrationality in your decision making.
Common cognitive biases include:
- Recency bias – This is the phenomenon of a person placing more value on new information than old information. For example, a conservative investor may want more equity exposure because they feel the recent returns are indicative of future returns. In turn they place less value on the information they gained in 2008 and early 2000s, and thus the past is masked with present.
- Confirmation bias – This is the tendency to seek out information that confirms an existing belief or investment thesis. Asking Google “how high will the stock market go”, rather than “what is the average return of the stock market”, will yield very different results. The first question will flood your feed with optimistic articles and blog posts, whereas the second will likely provide a set of data that includes both good and bad years and set the stage for a more rational and objective analysis.
- Illusion of control – You may be prone to believe you’re in more control of market outcomes than you actually are. Stressful situations can heighten this bias, such as investing in volatile markets. The result can encourage you to trade more often than necessary (reducing net returns) or taking large positions within a small amount of investments (lack of diversification, over concentration).
- Anchoring – Investopedia defines this as “the use of irrelevant information, such as the purchase price of a security, as a reference for evaluating or estimating an unknown value of a financial instrument.”1 This psychological benchmark is irrational, and in many ways, irrelevant to the underlying value of the investment you hold. Just because you bought it at $45 on Monday does not mean that this should be the benchmark on Tuesday. Instead, take an objective view on the characteristics of your investment and its relevancy to your long-term goals.
By working with an advisor you trust, you may be better prepared to react calmly and unemotionally in times of market changes. If you do tend to take an emotional approach to your investment decisions, you may find that an extra set of eyes on your portfolio to be worth it. This can be done, for example, by connecting with a fee-only hourly advisor that simply provides unbiased and objective feedback on your portfolio.
Strategy 2: Write Your Strategy Down
Do you have a favorite family recipe? White chicken lasagna is one of mine. My wife has made it so many times, the recipe is practically etched into her head. But let’s say she goes to make the dish and gets distracted with our two children. With her focus elsewhere, she may start to question what should be second nature. Was it 1 ¾ cup of alfredo or 1 ½? It was in the oven for an hour, but now it seems like an awfully long time. Maybe it was supposed to in for only 45 minutes? Before she begins to panic, she grabs the recipe card her grandmother made years ago and double checks the recipe. Within minutes, total peace of mind sets in that everything is on the right path for another wonderful dish.
Think of your investments in the same vein. Creating a disciplined and repeatable process, and having this written down for future reference, will provide you with the same reassurance when doubts arise, and your emotions begin to take over. If you’ve made a proper, thoughtful investment plan, you have likely already prepared for the good and the bad. Seeing this in writing can provide the relief that you’re doing the right thing.
Strategy 3: Set It And Forget It…For Just A While
There was a study conducted in 1979 (Kahneman & Tversky)2 that introduced the “loss aversion” principle. This principle is used to describe the phenomenon that the impact of a loss is greater than the benefits of a reward. For many investors, this principle can hold true - they feel much worse about a loss in value of their investments than they feel happy when those stocks are performing well.
As a result, some investors will sell their holdings during a dip in the market. If you purchased investment XYZ at $10 in hopes that it will go to $12, but it falls to $9 shortly thereafter, you may sell the position to avoid any further loss. Alternatively, you may have purchased investment at XYZ for $10 and refuse to sell it for anything less. This exposes you to unnecessary risk in that you may hold onto a loser for way too long, maybe even down to $0.
If this sounds like you, it might be time to take a step back from your portfolio. While regular review and rebalancing is often necessary, you may want to resist the urge to check on your stocks too frequently (daily, weekly or even monthly). Once you’ve put your plan in writing (strategy #2), stick with the plan and review your investments every three to six months.
Strategy 4: Don’t Predict The Future, But Do Remember The Past
“Those that have knowledge don’t predict. Those who predict don’t have knowledge.” - Lao Tzu
Both new investors and seasoned investors alike can gain value from reading up on market history. Depending on your depth of investment knowledge, you may already know what a bull market (on the rise) and a bear market (falling downward) are. But if you’re looking to better prepare yourself emotionally, you may want to do a bit of research into what historically happens in each market type. This isn’t an effort to beat the market, but instead an effort to beat your emotional response to the market.
Take bear markets for example. A bear market is one where stock prices decline by 20% from the near-term highs. Since 1926, there have been eight bear markets, ranging in length from six months to 2.8 years, and in severity from an 83.4% drop in the S&P 500 to a decline of 21.8%3. Oddly the one thing they all have in common, every single one, is that they recovered and the market subsequently hit a new high. That’s not to say that it will always happen, but instead that it has always happened.
Taking a historical view of the market can help you separate yourself and your stocks from the greater picture. This has the potential to make your investment decisions less behavior-based as you become more informed about past trends. As Mark Twain said, “history doesn’t repeat itself, but it does rhyme.”
Removing your emotions from your investments is easier said than done. And in some instances, it can be beneficial to take stock (pun!) of how market changes make you feel. Intuition isn’t always wrong when it comes to investing.
Revisiting your written plan once or twice a year is a great idea. You may have had external factors affecting your biases the day it was originally drafted. Does it still reflect your long-term goals? Your comfortability with a market downturn is a good time to test whether or not your risk tolerance is at the appropriate level.
But as you tune in to the nightly news or read about your favorite company online, remember to step back and think about your portfolio’s big picture. Remember the long-term goals you have in place. Remember the ups and downs of historical market reference. Most of all, remember that the best investment strategy is one you stick with. Be mindful of your emotions and appreciate rationality. You can do this!
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