The field of behavioral finance studies how people make decisions, and looks at how investors behave in real-life financial situations. It teaches us that both positive and negative emotions influence how we make decisions. When investors throw reason out the window and make decisions based on their feelings instead of logic, they may make the wrong choices and wind up with a portfolio that does not reflect their long-term goals.
Here are some common missteps that emotional investors make:
Overreacting to short-term market conditions
Mainstream news media reacts quickly to short-term, real-time events. So what a news outlet reports on one day can be contradicted only hours later. And markets tend to overreact to short-term noise. It’s important to keep your focus on your long-term goals, rather than responding rashly to media news. Keeping to a strict investment discipline reduces the impact of emotions.
Overconfidence can hurt your portfolio. If you take excessive risks and ignore the advice of investment pros, your portfolio may take a beating during a bear market, and you could compromise the investment strategy you’ve established.
Acting out of fear
Rather than rational thinking, acting out of fear can lead you to panic, make impulsive decisions, and sell securities after they’ve lost value, even if there’s a strong possibility that they may eventually bounce back. Fear can also result in investment paralysis: if investors are so frightened that they play it too safe, or do nothing, they can miss out on market rallies and other potential opportunities.
Copying the behavior of others often leads to unfavorable investment outcomes, such as buying high and selling low.
Trying to time the markets is futile, and dangerous, because it’s almost impossible for anyone to time the markets successfully for any period of time. History shows us that what actually happens is that investors have increased their holdings of stocks near the top of the market, and sold their positions when prices were near the bottom of down markets.
This theory holds that the pain of a loss is felt much greater than the pleasure felt from a financial gain of the same size. As a result, many investors act to avoid short-term losses, but that comes at the expense of their long-term objectives.
Failure to adequately diversify
Investors often don’t recognize that their portfolios need to be more diversified. If the investments you hold are correlated, they may react the same way during periods of market decline, for example. Correlation describes how two asset classes (such as stocks and bonds) move in relation to one another. When two asset classes are highly correlated, they tend to move with each other in the same direction. Choosing investments that aren’t correlated is important in helping reduce the overall risk or volatility of your portfolio. Developing an asset allocation strategy that includes a good mix of stocks, bonds, cash and other investments will help you stay more committed to your long-term plan.
What is the best way to avoid emotional investing?
It’s important not to deviate from a sound, long-term buy-and-hold strategy. If you need help creating or sticking to your plan, you can work with an experienced financial professional who can help you:
- Develop a personalized investment plan that assesses your needs, goals, time horizon, and risk tolerance
- Tell you what is realistic or unattainable
- Select suitable investment vehicles
- Monitor and rebalance your portfolio as needed over time
- Stay on track and avoid making impulsive decisions
Anita Morin is a Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). OSJ: 1040 Broad Street, Suite 202 Shrewsbury, NJ 07702, 973-244-4420. Securities products and advisory services offered through PAS, member FINRA, SIPC. This firm is an agency of The Guardian Life Insurance Company of America (Guardian), New York, NY. International Planning Alliance is not an affiliate or subsidiary of PAS. Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. Links to external sites are provided for your convenience in locating related information and services. Guardian, its subsidiaries, agents, and employees expressly disclaim any responsibility for and do not maintain, control, recommend, or endorse third-party sites, organizations, products, or services, and make no representation as to the completeness, suitability, or quality thereof.
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Prepared by The Guardian Life Insurance Company of America. The information contained in this article is for general, informational purposes only. Guardian, its subsidiaries, agents or employees do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.