Following the post-COVID stimulus hangover in 2022, the bull market has continued to run. One of the key factors was the Federal Reserve’s decision to
Emotional Investing and How to Avoid It
Published Date : October 25, 2022
October 25, 2022
2022 has delivered some record drops in both the stock and bond markets. In the month of September alone, the S&P broke below the previous June closing low, declining 1.03%. Similarly, the Dow dropped another 1.11%. This type of volatility can be incredibly stressful for investors, and understandably so, but it should not be a time to panic. Instead, it’s often a sensible time to lean in. Investing based on our strongest emotions (like fear, greed, envy, or regret) can typically have very detrimental long-term effects on the “health” of our assets. In fact, the biggest risk may not be the volatility of the market itself, but instead, our reaction to the volatility.
Emotional investing is often tied to the media and the firehose of information we are constantly facing—more so than ever before with the advent of 24/7 social media. And following all the twists and turns—and many dire predictions—can often induce bad timing in decision making. Historical analysis of collective money flows of investors buying at the top and selling at the bottom prove this point. Data reflecting new flows of funds into and out of mutual funds often shows that when markets are hitting peaks or valleys, buying or selling is at its highest, respectively.
In periods of volatility, it’s important to tap into—or get help in making—rational decisions. Giving in to fear (or even greed during euphoric periods) is often not a desirable strategy. The fact is the average investor gets the timing wrong. Studies conclusively show that the average investor underperforms the market over time due to moving in and out of investments way too often.
The typical market cycle of emotions is something that most if not all of us regularly experience in response to market conditions. The timeline follows optimism, euphoria, fear, surrender and then ultimately, back to the beginning. The best way to avoid adversely acting on some of these traps and protecting ourselves from our own emotions is to have a well-defined investment plan in place. It’s also important to remember that bear markets have consistently been shorter than bull markets. And while corrections are inevitable and unpredictable, they are also part of a normal market.
Time horizon, risk tolerance, and goal setting are all important factors in reducing the ever-present urge to trade on emotional instincts. Do you have more than five years in which you will need these funds? If so, you will likely see a market downturn in that span of time. Knowing ahead of time that you planned for the good, the bad, and the ugly market returns can help keep the focus on the long term instead of being derailed by constant shorter-term events.
There is risk inherent in nearly everything we do but it can usually be actively managed. Often, multiple different types of risk exist, from daily price action to longer-term purchasing power concerns. Proper identification and measurement of various risks and keeping them all aligned with your goals are key factors in determining proper portfolio allocation. And having the proper allocation and strategy can make a huge difference in how one reacts to volatility, including the right mix of stocks, bonds, cash, and other alternatives that minimize overall risk while striving to meet your needs and objectives for return expectations. As life goes on, and situations change, your allocation likely will, too.
Just like life, financial markets have cycles. As it relates to market cycles, emotions tend to get in the way. Fear and greed can beat out the rational mind, and hence too many investors end up acting on what they want to do instead of what they should do. Successful investors do the opposite.
Sources:
www.fidelity.com/spire/the-market-cycle-and-investors
www.doughroller.net/investing/heres-what-you-should-do-instead-of-panic-selling/#the-bottom-line
www.investopedia.com/articles/basics/10/how-to-avoid-emotional-investing.asp#toc-bad-timing
www.fool.com/investing/2018/02/07/warren-buffetts-playbook-for-a-stock-market-correc.aspx
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