You may have heard that investing should be a completely emotion-less endeavor: that it’s more of a science than art, and that you should stick to a system. I think that’s all true, but it’s easier said than done. Emotions have no place in investing, but the fact is that they’re there anyway. Why does it matter, and what can we do about it?
The Ideal
It would be great if we could invest without letting our emotions get in the way. We’d set up a system and let it run on autopilot while paying attention to more important things in life. When the markets go haywire, we would say to ourselves with a relaxed smile, “Oh, I hadn’t heard about that. But things are bound to get crazy from time to time… This too shall pass.”
Life would be easy, and we’d be more likely to reach our goals.
The Reality
The emotions of investing
We’re human beings, so the odds of reaching that ideal are slim to none. Even if we know better, at some point in our lives we’ll forget. The world can become a scary place when you’re losing money quickly, and the media only makes it scarier. On the flip side, you might hear about great ideas from people that you like and respect, and you may be motivated by (just a little bit of) greed to roll the dice.
After all, you want to be proactive and do what it takes to make your financial goals a reality. But you might not be sure how best to do that (I have some suggestions further down).
By the way, I might come off as some kind of smarty-pants telling you all this, but I’ve made these mistakes myself. I’m sure I still slip up sometimes.
The Cost
It’s probably no surprise that emotional investing is more likely to hurt you than to help you:
- Market timing is difficult, and rarely works out (anybody who says otherwise is either magical, new to the game, or has selective memory)
- Following your emotions is stressful, as you try to take control of and responsibility over something that you cannot control
- Reacting to the markets is expensive unless somehow you pay zero transaction costs and avoid short-term capital gains
- The result of investing with your emotions is generally that you’ll buy high and sell low. You’ll miss out when things are good, and you’ll dive in headfirst as the tide is heading out. Not convinced? Just ask the people who invested in the “best” mutual fund over the period of 2000-2010 (they lost money, but the fund didn’t).
What to Do
Given the challenges you face and the cost of emotional investing, what can you do?
Be aware: this is the first step, and probably the most important one. You have to notice when you’re tempted to follow your emotions (as opposed to your plan). When you can do this, you’re in a stronger position than most investors. Think of it however you want: mindfulness, knowing thyself, or check-yourself-before-you-wreck-yourself.
Build a foundation: do a good job of setting up your investments before things get crazy. Get a well-diversified portfolio, and take the right amount of risk for your goals and your situation. Do this in an unemotional state, when the world is not coming to an end. If you know that you are prone to freaking out when the markets go down, you might not want a super-high-risk portfolio. It will only make you freak out someday – why put yourself through that? When you’ve done a good job of setting things up, you can feel more confident that you’ll weather any storms reasonably well (and you can also feel confident that you’re already doing everything you can – if you’re ever tempted to take unreasonable risks).
Know the numbers: have you ever calculated how much you really benefit from speeding? Unless you go really crazy, you’re not saving yourself any time and you’re paying for it in a variety of ways (not to mention taking meaningful risks and enjoying yourself less). The same might be true for your investment goals. Market timing and active trading might improve your returns if you’re one of the lucky few, but if you want a safer bet, why not figure out what will actually make a difference? The chart at the bottom of this page shows how long it takes to reach a goal depending on how much you invest and how much you earn on investments. You can invest more, earn more, or both. But unless time is really on your side, investing more is the way to go (and you never know if you’ll actually be able to earn more).
Cool your jets: if you notice that you’re super excited or super depressed, it’s not the right time to take action. Those feelings are certainly helpful in alerting you to something, but they might not be helpful in making investment decisions. Let the dust settle a bit. It is unlikely that you need to do something rash immediately. It’s possible that time is of the essence, but for most long-term investors those instances are few and far between. Ask yourself: is this one of those instances?
It’s a marathon: remember the big picture. Think back to that solid foundation that you set up – your long-term goal with your long-term strategy for reaching it. Things can change quickly, but does that mean you should change what you’re doing? It’s probably best to make changes only when something changes in your life (your employment situation, your health, your goals, etc.) – not when the market changes direction.
Unplug: watching the financial news everyday (or checking your accounts) can only make you crazy. Don’t do it. For most people with long-term goals, a few times a year is more than enough to review your finances.
Photo credit: @thedeiwz