Financial Insights

How To Recognize and Avoid Emotional Investing

We wrote a piece this summer about the importance of maintaining equities in your portfolio and how, academically, equities provide the best investment outcome over long periods of time.  In contrast to what we know academically, we also talked about the psychological benefits of maintaining cash and how “cash can buy happiness”.

There is no doubt that our emotions do play a role in investing.  It’s unavoidable for even the most sophisticated investors and the volatility of financial markets reflects our fear and greed over time.

Today we’re sharing some thoughts on common situations where our emotions get the better of us and make it more difficult to achieve investment success and reach our financial goals.  The hope is that if we can recognize the symptoms, then we may be better prepared to understand them and avoid making mistakes.

Fear of losing money. As I mentioned over the summer, the pain of loss is said to be three times more impactful as the satisfaction provided by a similar gain.  So we go to great lengths to avoid loss and this often creates investment paralysis.  Symptoms of investment paralysis include avoiding investing altogether (which makes meeting financial goals difficult or even impossible) or selling winning investments (for fear of losing the gain) while losing investments are left in the portfolio indefinitely.

The reality is that investments in stock and bonds are gaining and losing value all day, every day. We only lose money if we happen to sell something for less than what we purchased it.  Fortunately, our personal investment time horizons are much longer than just a day and with proper planning, we can and should avoid losing money by choosing a strategy the fits with our goals and then staying invested.  Over the time periods that represent major investment goals, like a normal retirement today, properly managed investment portfolios add value (be it through income and/or appreciation) over time.

Following the herd. The opposite emotion of fear that can overwhelm an investor is greed.  Symptoms include owning the hot stock or fund or economic sector and following the crowd (i.e., chasing performance) while it’s likely that these investments have already run up and that real value lies elsewhere.

It’s a challenge to go against the consensus and take our emotions out of investment decisions.  It’s easier to follow the money and follow the crowd because most of us would prefer to suffer along with everybody else than to win all alone.  The risk here is that the crowd’s goals may be very different than your individual goals.  And when the crowd includes influential family members and friends, it can be more difficult to break from the herd and so it’s important to recognize this.

Chasing stars.  Investors typically choose active managers in an attempt to outperform the market. According to one estimate, 85% of the new money going into domestic equity mutual funds goes to funds with Morningstar ratings of four or five stars.  Even Morningstar’s own head of behavioral research indicated that it’s “star ratings are clearly used in the industry to imply that funds that performed well in the past will do so in the future”.

This is one good reason for investors to heed the required government disclosure for investment products: Past performance is no guarantee of future results!  Despite the disclosure, investors (and advisors) continue to rely on these ratings as a shortcut to doing real research and without truly understanding the shortcoming of Morningstar’s rating system.  Morningstar’s ratings do not measure the success of a fund beating the market.  They measure the risk-adjusted performance of a fund relative to other similar mutual funds.

Star ratings and recent returns are not goals.  Abnormal returns, whether they are high or low, tend to return to the average in the long run.  Investing on the basis of the very highest recent returns runs a significant risk of getting in at the top of the price cycle, with a strong chance for disappointment.  High returns are often accompanied by high risks and, ultimately, those risks may undermine performance.

Reacting too Quickly.  Just like your investments are changing in value all day every day, there are new events and changes to ongoing concerns that we could react to on a seemingly daily basis.  The media has an influence on how we receive and interpret information today, which can affect how we feel and so it’s important to keep this in mind.

Generally speaking, markets overreact to news (whether it be stock specific or something broader) and then eventually revert to some equilibrium after the news is fully digested.  And sometimes, news is only revealed to the general public through some form of media when, in fact, this information is already reflected in the traded value of a particular stock or bond by those with greater knowledge.  Whenever possible, it’s better to let the market react to news than to be part of the reaction.

Over the course of this year, we’ve highlighted the fact that day to day events in Washington (or even who is President) tend to have little influence on the economy over time, but they are easy to react to.  If anything, they’re more interesting to talk about or even conversation starters.  Similarly, news of bad performance for an individual company (stock of bond) does not portend bad performance for the overall economy.

Over time, what really matters is the health of the economy.  By recognizing and distinguishing these influences, it may be easier to sort through the noise, keep the bigger picture and your goals in mind, and not react impulsively.

The Remedy

The best remedy to avoiding impulsive decisions where emotions get the better of us is to have a plan and stick to it (or to work with someone who you trust and can help you create and maintain a plan).  Your plan should determine the purpose of why you are investing and the investment strategy you choose should determine how you achieve your plan’s objective.  Expected returns need to be reasonable and linked to your time horizon.  Longer time horizons, like the length of a typical retirement today, give us more time to recover from bad years and more chances to be in the market for good years.

Academically, a portfolio of 100% stocks over the long term achieves the best investment outcome.  Emotionally, very few of us can tolerate the volatility that a 100% stock portfolio will experience.  The best way to moderate the impact of volatility in difficult markets is to maintain some balance and own some stocks and bonds and perhaps, if it makes us happy and doesn’t impair our ability to achieve our goals, keep some cash available too.  Assets do not move up down in lockstep. When stocks rise, bonds may fall.  Or at other times, bonds also may rise when stocks do.  A Balanced approach should make the ride smoother and make it easier to remain invested, which is the key to investment success.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.


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