Investors who make decisions based on their feelings typically underperform the market. Bull markets are driven by greed, the desire to be more shrewd than other investors. Investors’ emotional investments manifest as panic selling during bad markets. Both of these are terrible for the returns of investors.
Most individual investors make the mistake of trying to outperform the market instead of at least keeping pace with it.
The Data
According to research by DALBAR, the typical investor lost 9.42% last year. However, the losses suffered by the S&P 500 were only 4.38%.
In other words, that year wasn’t an outlier. They discovered that the typical investor earned only 5.96% from 2001 to 2020, while the S&P 500 returned 7.43% during the same time period.
It has been shown in other research that investment returns are negatively impacted by human emotion. It was shown in a study published in the Journal of Financial Planning in 2018 that investors who removed their emotions from their investment decisions had their returns increase by up to 23% over a 10-year period.
Investing should be done with logic and reason, not feelings, as has been concluded in every study I’ve read on the subject. However, human beings are herd animals and are therefore influenced by herd psychology.
When everyone else is selling their stocks because they fear losing everything, we feel the same terror and have the need to sell before we, too, lose everything. When the market is doing well and everyone else is buying, we feel the opposite and don’t want to miss out on the profits.
To what extent can we control these strong emotional urges that wreak havoc on our financial returns? It all begins with a strategy.
Developing Your Individual Core Investment Plan
When I have lost money in the stock market, it has always been because I deviated from my basic strategy. More precisely, before I established my primary investment strategy in light of my monetary objectives. One should develop a personal investment philosophy and then implement it mechanically.
There is absolutely no harm in having one that looks different from mine. However, it should represent professional guidance, whether from a human financial planner or a computerized Robo-advisor more on these in a moment.
Core Investing Plan Example
To summarize my primary investment strategy: I put 60% or more of my wealth into index funds that are managed passively. They include both domestic and international funds, as well as small, mid, and big-cap options. I buy stocks primarily for long-term growth and diversification.
Forty percent of available funds are invested in real estate, either directly or indirectly. For a number of reasons, including tax benefits and protection against inflation, I have chosen to put my money into real estate.
Each and every one of my stock trades and purchases are handled automatically. Since my real estate ventures involve more time and effort, this is a huge relief.
I enjoy seeing my wealth grow as a result of increases in the value of equities and real estate. Still, I take satisfaction in the fact that a decline in value affords me the opportunity to purchase valuables at a discount.
However, there are moments when I am inclined to try to time the market. Although rationally I know it would be a bad idea, I can’t resist the temptation to give in to my feelings and do it anyhow. Therefore, as a form of compromise, I have set aside some play money.
Compromise over “Play Money”
About 10 percent of my investment fund is reserved for taking risks, investing in novel ideas, and exploring new opportunities. Some time ago, for instance, I put a small amount of money into the cryptocurrency market.
I understood it to be high-risk speculation and admitted that I didn’t know much about the factors that determine the value of cryptocurrencies. Yes, I did it anyhow, but only with pretend cash.
Using fake funds, I have invested in private real estate investment trusts (REITs) through platforms like Fundrise and Streitwise. As I establish a pattern of steady profit from these investments, I plan to make them a bigger part of my overall strategy. And yet, I tested the waters first using dummy funds to see how things worked.
Despite my best intentions and recommendations, I still try to time the market. When the stock market drops suddenly and dramatically, I tend to increase my automatic investment of assets into index funds. When I want to take a risk, I use my 10% play money allocation rather than adjusting my main investment approach.
You need not completely forgo active investing, day trading, or alternative investments if you love them. Keep your irregular investments to no more than 10% of your capital to reduce the impact of your emotions on your decisions and increase your profits.
How to Manage Your Emotions When Investing
The process of developing a personal investing strategy is only half complete. You must carry out the plan in its entirety if you want it to succeed. That’s why it’s so important to automate your financial management and investment processes.
The benefits of automating your financial management include increased efficiency, decreased stress, improved long-term wealth accumulation, and higher returns and savings rates.
If that all sounds fine to you, then put your financial investments on autopilot and let your money work for you without your emotions getting in the way.
1. Make Savings Automatic
Why don’t you just tell me where you can acquire some investment capital? Cutting back on frivolous spending and allocating a sizable portion of one’s income to savings and investments is one way to do this.
Assumptions and financial history may have crept into your old budget, so it’s best to start fresh. If I asked you to make some minor adjustments to your current budget, it’s unlikely that you’d consider doing away with your mortgage altogether.
As an unavoidable cost, it would be disregarded by you. But housing costs more than any other category in most people’s budgets, making it an ideal place to cut costs.
Save at least that much of each paycheck you receive after taxes from now on. These funds ought to be sacred and your top financial priority. You can avoid temptation by always putting this sum toward your goals.
Set up an automatic savings plan to ensure that whatever money you earn gets straight into a savings or investment account, or, if paying off high-interest debt is a priority, into that account.
Automatic savings apps like Acorns and Chime, direct deposit split across multiple accounts, and regular transfers from your bank to your savings account on pay days are all viable options.
By setting up an automatic savings plan, you eliminate the temptation to spend the money. Rather than just sitting in a bank account doing nothing, it is always putting in hard work on your behalf.
2. Fully Automate Your Investments
I use a Robo-advisor to manage my stock investments since it invests my money automatically and makes the necessary transactions from my bank account.
Robo-advisors have greatly expanded the pool of potential investors by providing professional guidance and portfolio management to people with lower and intermediate incomes in the United States.
Actually, many of the top Robo-advisors don’t cost you a dime. For two excellent examples, see SoFi Invest and Charles Schwab. A Robo-advisor automates the investment process so you don’t have to. Every week, without fail, everything happens automatically in the background.
That doesn’t mean you can’t succumb to emotional selling during a market downturn or excessive buying during a sputtering bull run, but it does mean you’ll have to make a conscious effort to make rash decisions about your portfolio.
However, Robo-advisors can provide assistance in more than just the automated realm. In addition to assisting with diversification, dollar-cost averaging, and routine rebalancing, these tools can help you invest with less emotion.
3. Average Cost in Dollars
Dollar-cost averaging may be a sophisticated financial word, but it actually relates to a straightforward strategy. By consistently spending the same amount of money at regular intervals, known as dollar-cost averaging, investors can avoid the risky practice of trying to time the market.
You keep making the same scheduled investments whether the market is up or down. It’s a simple and effective technique to lower portfolio risk. You don’t need to second-guess yourself about whether or not now is a good moment to invest; you should just keep investing.
Dollar-cost averaging is a method of investing most often employed with index funds that causes your returns to track those of the index when averaged over time. In the long run, it dampens the impact of the market’s short-term ups and downs, allowing you to achieve returns that are on par with the index.
For my Robo-advisor account, I programmed a regular withdrawal of the same amount to occur every two weeks. When it reaches my Robo-platform, the advisor’s it is invested in accordance with the asset allocation it recommended for someone with my demographics and aspirations.
4. Spread Out Your Investments
Picking individual stocks is a high-stakes gamble. Unless you are a professional, stock picking should not form the basis of your investment strategy. Do it, but only with pretend money if you really have to.
Trying to pick stocks has cost me dearly more than once. When marijuana was first legalized, I foolishly thought I could gain ahead of the curve by buying stock in a few marijuana companies.
Almost all of my investment capital was wiped out, in part because of pervasive fraud in the market and in part because I lacked the knowledge necessary to invest wisely.
The Department of Justice still sends me emails asking if I want to join class action lawsuits against some of those dot-com busts that artificially inflated their stock prices before draining their own coffers.
If not, then what should you do? You should spread your bets around by investing in a variety of index funds, such as U.S. and foreign, small-cap and large-cap mutual funds, or exchange-traded funds (ETFs) across a variety of industries.
Choosing which index funds to invest in is done automatically for you. After signing up with a Robo-advisor, you will be asked to fill out a short questionnaire about your investment objectives, level of comfort with risk, and other personal information.
After that, they will provide an asset allocation strategy for you to approve or modify. Those adages about not putting all your eggs in one basket aren’t made up for no reason. This is solid guidance for handling one’s finances.
But the optimal asset distribution for you will change over time. As you get older and closer to retirement, your Robo-advisor may make the necessary adjustments.
Your portfolio’s actual asset allocation will change over time as a result of the relative performance of your various holdings, even if you maintain a constant target allocation. And that’s where rebalancing comes in.
5. Make Your Rebalancing Automatic
As the value of your investments “drifts” away from your initial asset allocation target over time, you will need to rebalance your portfolio to get it back to where you want it to be.
In any given year, there will always be certain assets that do better than others. It would not be such a bad idea to let your money ride on the top performers instead of selling some of them and reinvesting in the losers.
However, this is another example of how your emotions can affect your financial decisions. You should always follow your predetermined asset allocation strategy.
As a first benefit, it aids in risk reduction. While stocks often generate far higher returns than bonds, this superior performance is not without its drawbacks, including greater volatility and risk. Along with minimizing dangers, rebalancing your portfolio can help you earn more money. If your investments are doing well, selling them will require you to take a loss.
Investing in something that has lately underperformed means you have to buy low. For sure, it’s nicer to just let your gains ride. In fact, this is why you should never bring your feelings into your investment decisions.
6. Prevent Retirement Anxieties With Planning
Pensions and sizable Social Security payments are a thing of the past. Planning for one’s own retirement is only one of the numerous ways that retirement has evolved over the past generation in the United States. But the typical American is nonetheless financially and financially-literate-ly unprepared for retirement.
Safe withdrawal rates and sequence of returns risk are two retirement planning fundamentals that many people misunderstand. Most people have no idea how much they should have put up for retirement by now.
As a result, they are easy targets for scams, shortcuts, and panic selling when it comes to their retirement savings. Investing in retirement should be carefully planned out with the help of a financial counselor.
Don’t feel compelled to give someone else control of your finances; many advisors now offer hourly rates for their guidance. While your Robo-advisor may be helpful, it may be best to discuss your strategy with a real person.
These considerations should be incorporated into that strategy:
- When it comes to retirement planning, how much do you need to put away?
- How much money should you put into each type of investment each year until you retire?
- To what extent can you live off your nest egg annually once you’re retired?
There isn’t any emotional weight to any of these inquiries. Furthermore, there is no place for sentimentality in the responses. Finally, a safe withdrawal rate can be estimated by subtracting your age from 100, 110, or 120.
This number will vary based on your comfort level with risk. The figure you arrive at is the proportion of your investment portfolio that should be held in equities. The remaining funds should be invested in safe, yield-seeking vehicles.
One hundred should be used if one’s risk tolerance is low. You should go with 120 if you’re willing to take more chances.
Bottom Line
If you let emotions and the psychology of the crowd influence your investment decisions, you will see your results plummet. They suggest that you should buy low and sell high.
This, however, necessitates a strategy of purchasing when widespread fear has driven prices down and selling when widespread greed has driven prices up. It involves going against the grain of the current climate and sticking to a plan of action.
No, it doesn’t mean you should try to predict the market. It suggests setting up automatic savings and investing plans, sticking to them, and avoiding the temptation to meddle.
If you do that, you will get much higher returns than the typical investor, not to mention less time and money spent worrying about money.
