How to Avoid Emotional Investing

Investor Behavior

Investor behavior has been the focus of many studies and numerous theories attempt to explain the regret or overreaction that buyers and sellers often experience when it comes to money. The reality is that the investor's psyche can overpower rational thinking during times of stress, whether that stress is a result of euphoria or panic. Taking a rational and realistic approach to investing—during what seems like a short time frame for capitalizing on euphoria or fearful market developments—is essential.

The non-professional investor is typically putting hard-earned cash in investments for the sake of receiving a return. Still, they see their investments lose value due to market developments at times. The losses can cause stress and second-guessing. That is, many investors have a relatively low risk tolerance when it comes to investing because losing money is painful.

But risk can be viewed as a guidepost for investing and investor behavior. Investors who enter into investments with a base level understanding of the risks involved can mitigate a great deal of the emotion associated with investing. In other words, challenges due to emotional investing can crop up when investors see unidentified or higher stake risks than they had originally ascertained.

Bull vs. Bear Markets

Bull markets are periods when markets move up relentless and, sometimes, indiscriminately. When the bull rages and investor sentiment becomes one of general exuberance, investors might see market opportunities or learn about investments from others—such as news stories, friends, co-workers, or family—that may compel them to test new waters. The excitement might lead the investor to try to obtain gains from investments that are emerging due to bullish market conditions.

Likewise, when investors read stories about a bad economy or hear reports about a volatile or negative market period, fear for their investments can fuel selling. Bear markets are always lurking around the corner and come with many of their own caveats that can be important for investors to follow and understand. In contrast to a bull market, sometimes financial markets can trend lower for many months or even years.

Oftentimes bear markets evolve from an environment of rising interest rates that can spur risk-off trading and a transition from riskier investments like stocks to low-risk savings products. Bear markets can be difficult to navigate when investors see their equity holdings lose value while safe havens become more enticing due to their rising returns. During these times, it can be hard to choose between buying equities at market lows or buying into cash and interest-bearing products.

Bad Timing

Emotional investing is often an exercise in bad market timing. Following the media can be a good way to detect when bull or bear markets are evolving because the daily stock market reports feed off the activity occurring through the day, which can at times create a buzz for investors. However, media reports can also be outdated, short-lived, or even non-sensical and based on rumors.

At the end of the day, individual investors are accountable for their own trade decisions and therefore must be cautious when seeking to time market opportunities based on the latest headlines. Using rational and realistic thinking to understand when an investment may be in a development cycle is the key to evaluating interesting opportunities and resisting bad investing ideas. Reacting to the latest breaking news is probably a sign that decisions are being driven by emotion rather than rational thinking.

Time-Tested Theory

The notion that many market participants buy at the top and sell at the bottom has been proven by historical money flow analysis. Money flow analysis looks at the net flow of funds for mutual funds and often shows that, when markets are hitting peaks or valleys, buying or selling are at their highest.

Market anomalies like a crisis can be useful time periods for observation. During the financial crisis of 2007-2008, investors withdrew money from the market and money flows to mutual funds turned negative. The net fund outflows peaked at the market bottom and, as is typical for market bottoms, the selling created overly discounted investments, which eventually formed the basis for a turning point and the market's next ascent upward.

Strategies to Take the Emotion Out of Investing

Two of the most popular approaches to investing—dollar-cost averaging and diversification—can take some of the guesswork out of investment decisions and reduce the risk of poor timing due to emotional investing. One of the most effective is the dollar-cost averaging of investment dollars.

Dollar-cost averaging is a strategy where equal amounts of dollars are invested at a regular, predetermined interval. This strategy can be implemented in any market condition. In a downward trending market, investors are purchasing shares at lower and lower prices. During an upward trend, the shares previously held in the portfolio are producing capital gains and, since the dollar investment is a fixed amount, fewer shares are purchased when the share price is higher.

The key to the dollar-cost averaging strategy is to stay the course. Set the strategy and don't tamper with it unless a major change warrants revisiting and rebalancing the established course. This type of strategy can work best in 401(k) plans with matching benefits, as a fixed dollar amount is deducted from each paycheck and the employer provides additional contributions.

Diversification, which is the process of buying an array of investments rather than just one or two securities, can also help diminish the emotional response to market volatility. After all, there are only a handful of times in history when all markets have moved in unison and diversification provided little protection. In normal market cycles, using a diversification strategy provides an element of protection because losses in some investments are offset by gains in others.

Diversifying a portfolio can take many forms such as investing in different industries, different geographies, different types of investments, and even hedging with alternative investments like real estate and private equity. There are distinctive market conditions that favor each of these investment groups, so a portfolio made up of all these various types of investments should provide protection in a range of market conditions.

The Bottom Line

Investing without emotion is easier said than done, but there are some important considerations that can keep an individual investor from chasing futile gains or overselling in panic. Understanding your own risk tolerance and the risks of your investments can be an important basis for rational decisions. Active understanding of the markets and what forces are driving bullish and bearish trends is vital as well.

Overall, while there are times when active and emotional investing can be profitable, data shows that following a well-defined investment strategy and staying the course through market volatility often results in the best long-term performance returns.