Investing based on emotion (greed or fear) is the main reason why so many people are buying at market tops and selling at market bottoms.- Investopedia
Anxiety and stress levels rise during periods of uncertainty; and in a stressed emotional state, a person’s ability to make rational decisions is meaningfully impaired. – H. M. Payson
A study performed by Nobel Prize-winning psychologist Daniel Kahneman showed that we make financial decisions based 90% on emotion and only 10% on logic
“Unsuccessful investors are dominated by emotion.” Seth Klarman
“Most of the errors in our business are errors of emotion.” Howard Marks
Impact of emotional investing
Consider an analysis of 2018 returns by Dalbar. In 2018, the S&P 500 lost 4.38%. The financial analytics firm found that the average individual investor lost more than double that, at 9.42%. They lost money because they panic-sold when the market declined — they sold low. Those who shied away from stocks missed out on the longest bull market in history, from 2009 to 2020. They let their fear and loss aversion get in the way of building wealth. Fear is the enemy of investing because it keeps you from taking advantage of rare “fire sale” opportunities. The best time to invest in an asset is when the herd panics and prices plummet.
The same logic applies to the buying side of the equation. Too many would-be investors sit on the sidelines in the early stages of market upturns out of fear then start seeing dollar signs as they watch the stock market climb. But by the time they witness enough growth to feel green with envy and greed, much of the bull market may have passed entirely. In fact, the best weeks and months of a recovery tend to be the first ones. In the first month after the S&P 500’s low in October 2002, it rose 15.1%. After the S&P 500’s low in March 2009, it leapt 26.6% over the next month. Investors who waited for greed to drive them into the market missed out on much of the recovery.
Have you ever sold an investment because you felt frustrated by its performance only to see it surge after you did? Anger and frustration can make you dump fundamentally sound investments just because you get tired of waiting for them to show progress. Yet overreacting in frustration and impatience often robs you of your best investments and ideas.
In good markets and bad, the average investor underperforms the market. In the 20 years from 1996 to 2015, the S&P 500 generated an annualized return of 9.85%. Yet Dalbar found that the average investor earned roughly half that: 5.19%. There’s an old saying on Wall Street that “bears make money, bulls make money, and pigs get slaughtered.” “Pigs” are the wafflers, the investors who invest based on the emotion of the herd.
So, how does one control/manage emotions?
“Investing is an easy game, if you can control your emotions.” Warren Buffett
“Not being controlled by an emotion helps one to see things at a higher level.” Ray Dalio
Here are some tips to control your emotions:
- It’s natural to feel worried. Even experienced investors steeped in the market’s historical cycles may feel torn between emotions and knowledge. Don’t act when you are worried
- Sleep on major decisions before taking action. A 24- to 48-hour window of reflection may help investors avoid making potentially destructive, short-term decisions during volatile markets.
- A systematic investing strategy (based on process, not emotion) can help investors focus on their long-term goals, rather than short-term market fluctuations.
- Diversification spreads your money among different asset classes, sectors and geographies and can blunt the impact of market downturns.
- Stay away from information overload. Objective research helps.
- Do your homework well. Conviction is always gained from self-work rather than a derived one. Stay away from tipsters.
- Avoid checking on short term portfolio performance. A strong portfolio smoothens anomalies in the long term
- Work with a financial professional, and before making any decisions, discuss your concerns to help keep those market emotions in check. Work together to keep your long-term investment strategy on track.
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