The biggest investing mistake
Why emotion Is the enemy of investing
Professional investors often dive deep into technical analysis, looking for that perfect predictor of market turns. Even then, many get it all wrong, let alone those of us who don’t have a doctorate in economics.
The good news: You can earn strong returns with a completely automated investment strategy.
The bad news: Your emotions fight you tooth and nail along the way, damaging your returns if you surrender to them.
A 2018 Journal of Financial Planning study found that investors who use a behaviour-modified approach to investing that removed emotion saw returns up to 23% higher over 10 years. As the study ended before Covid heavily impacted investment markets, it’s fair to assume the difference would be even more nowadays! With more Kiwi adults diving into their own investing than ever before, self-managed investing has become a critical life skill for many.
That means any DIY investors need to learn how to manage our financial emotions if they ever hope to retire comfortably, or achieve other life goals.
Resisting herd psychology
“Be fearful when others are greedy, and greedy when others are fearful.” Warren Buffett
We probably have all heard the old saying: buy low and sell high. But apply logic to that for a moment: to do so successfully, it means buying when the herd is selling (driving prices lower), and selling when the herd is exuberant (driving prices higher). For the avoidance of doubt, in this case the herd is all the other investors who together are setting the market prices of any given investment.
That’s far easier said than done. As herd animals, humans mirror the emotional response of the crowd. It served us on the savannah — when the alarm went up about an incoming predator, communal fear kept all members of the community alive. But as with so many undeveloped impulses, it doesn’t serve us well today, at least not in sophisticated areas such as investing.
The first step to separating emotions from your investments simply involves recognising the decision-making risk. Acknowledge that you are a herd animal, like all of us, and therefore subject to powerful emotional impulses based on those around you. Then acknowledge that those emotions and biases can often push you in the opposite direction of sound investing principles.
Emotions that negatively impact sound investing
In both winning and losing years for stocks (shares), the average investor earns lower returns than the stock market at large.
They underperform because they sell during downturns and only buy after financial markets show a strong recent history of gains rather than investing consistently for the long term.
That’s emotional investing. The three primary emotions that negatively impact your returns are fear, greed, and frustration or impatience.
Consider an analysis of 2018 returns by Dalbar. In 2018, the most common investment benchmark cited worldwide, the United States 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.
In contrast, the wealthy think differently about money, and they leave their money invested long-term rather than panic-selling.
Fear is the enemy of investing because it keeps you from taking advantage of rare “fire sale” opportunities. If at all possible, the best time to invest in an asset is when the herd panics and prices plummet, such as during the covid-impacted investment turbulence of early- and mid-2020.
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.
After waiting for a track record of growth before they feel comfortable investing, suddenly, they see those gains and want in on it.
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 good markets and bad, the average investor underperforms the market itself. 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 in the investment world that “bears make money, bulls make money, and pigs get slaughtered.” In this case “pigs” are the investors who invest based on the emotion of the herd.
Frustration or Impatience
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.
Granted, sometimes, new information comes to light that changes your fundamental analysis. By all means, stay flexible and don’t cling to bad investments out of stubbornness.
But if the fundamentals for an investment remain sound, don’t dump it just because other investors haven’t noticed it yet.
Always remain calm in investing and business. As long as your underlying thesis for your investment hasn’t changed, neither should your emotions.
Strategies for avoiding emotional investing & maximising returns
Intellectually, we might totally get it: emotion hurts your returns. But, that doesn’t make it easy to resist those emotions while in the grip of a stock market correction or bear market.
Avoiding emotional investor behaviour starts with a mindset shift. You must stop thinking of your investments as short-term assets and stop dwelling on the daily fluctuations in your net worth.
Take a long-term view of your wealth. Don’t think in terms of “I lost $20,000 in my portfolio today.” Think in terms of long-term averages and your long-term financial and lifestyle goals.
Take steps to automate your savings, and then automate your investments.
The bottom line
Emotion has no place in anyone’s investment decision-making process.
Data ranging from the 2018 Journal of Financial Planning study to the reports from Dalbar reinforce what investment advisers have been telling us all along. Check your emotions at the door before making any financial decisions, much less major ones involving thousands of dollars in assets.
Form an investing strategy based on your own unique financial goals and needs. Then automate it to continue operating regardless of the herd mentality and investor sentiment of the moment.
If you’d like to discuss anything above with a professional, or anything else related to this topic, please leave your details below to book an obligation-free initial consultation. We’ll get back in touch within a work day.