Take the emotion out of your investing
I frequently quote that we are physical beings run by our emotions: the way we feel affects our actions. That’s certainly true when it comes to investing, as historical data shows only too well.
For the 20 years up to December 2015, the S&P 500 Index, which tracks the stock market performance of the largest 500 companies in America, averaged returns of 9.85% a year. You could simply leave your money to follow the combined ups and downs of those companies and it would double in value every eight years or so.
In the same period the average equity fund investor however returned only 5.19% per year.
Why? Behaviour. How we behave when investing is often illogical, based on emotion not facts. Let’s highlight that with a couple of examples of typical money-losing moves that average investors make.
Study after study shows that when the stock market goes up, investors put more money into it. And when it goes down, they pull money out.
This is like going to the shops every time the price of something goes up, and then returning your purchases when there’s a sale on, at a store that only gives you the sale price back.
We are human, so we overreact to good news and get greedy; and we do the same with bad news and get fearful. Logic can easily go out of the window.
This tendency to overreact can become even greater during times of personal uncertainty, such as when we near retirement, or when the economy is slumping… like during a pandemic.
There’s an entire field of study which researches our tendency to make illogical financial decisions, called behavioural finance. It labels our money-losing mind tricks with terms like ‘recency bias’ and ‘overconfidence’.
One study analysed trades from 10,000 clients at a brokerage firm, aiming to ascertain if frequent trading led to higher returns. The results? The stocks purchased underperformed the stocks sold by 5% over one year, and 8.6% over two years. In other words: the more active the investor, the less money they made.
This study was repeated numerous times in multiple markets and the results were always the same. The authors concluded that traders are “basically paying fees to lose money”.
Overconfidence causes investors to exaggerate their ability to predict future events. They are quick to use past data, and to think they have above-average abilities that enable them to predict market movements into the future. Almost invariably, they are wrong.
One of the best things you can do to protect yourself from your own natural tendency to make emotional decisions is to seek professional guidance and hire a Certified Financial Planner (see how at warrenshute.com). A CFP can serve as an intermediary between you and your emotions… and that can make a serious difference to your returns.
5 things you need to know
If you are going to manage your own investments, you’ll need a way to keep your emotions out of the buy/sell process. Consider using the tips below to make smarter decisions.
- Do nothing. A conscious and thoughtful decision to do nothing is still a form of action. Have your financial goals changed? If your portfolio was built around your long-term goals (as it should be), a short-term change in markets shouldn’t matter.
- Money is soap. Economist Gene Fama Jr. said it best: “Your money is like a bar of soap. The more you handle it, the less you’ll have.”
- Never sell equities in a down market. You wouldn’t rush to put a For Sale sign on your home when the housing market turns south, so don’t rashly sell equities when there’s a bear market. Wait it out.
- Boring is best. It’s academically proven that a disciplined approach delivers higher returns. Yes, it’s boring, but it works. If you don’t have discipline, you probably shouldn’t manage your own investments.
- Diversify. Nobody can accurately predict the future, so spread your investments globally including equities and bonds using index or passive funds.