Emotions may be the single biggest detriment to your investment success. We try to approach investments from a logical perspective but we are emotional creatures and money can stir-up intense feelings. The most common emotions are fear and greed which can lead us to overreact and sell low when the market is down and buy high when the market is at a peak. Both actions are harmful to the performance of your investment portfolio. We can’t ignore emotions but we can better understand our emotional triggers and learn how to manage them.
You can minimize emotional reactions to fluctuations in the stock market by creating a plan. With some planning you can establish a diversified asset allocation that incorporates your investment timeframe, financial goals and tolerance for risk. A well designed asset allocation can ensure that money needed in the short term is placed in safer fixed income investments while long term money is invested in higher return, higher risk investments like stock mutual funds. As a general rule, money needed in the next five years should not be invested in the stock market. If you position your short term money in safer, less volatile investments such as money markets, CDs and bonds, you will be less likely to overreact and act on emotion.
When you invest in the stock market prepare yourself for volatility including some years with negative returns. Over long periods of time, the average return in the stock market has been around 9%, much higher than the average return for fixed income investments. However, stock market returns are not level. In some years, stock market returns will be higher than average and some years they will be lower than average. If you are prepared for this and maintain a long time horizon you will be more likely to stay on course.
Be wary of sensational news reports that claim the world is coming to an end and everything is different this time. The stock market goes through cycles and there will always be scandals, bubbles and crises getting blown out of proportion by the media, financial pundits or financial companies trying to sell you something. An example of this is commercials that use fear tactics to encourage you to buy gold and silver. They prey on the fear and uncertainty investors experience during a significant market drop.
Buying on emotion can also be detrimental to the long term performance of your portfolio. We have a natural fear of missing an opportunity. Avoid chasing the latest hot asset class or following the crowd because you don’t want to miss out. Assets performing well this year may be next year’s losers and investments with abnormally high returns aren’t sustainable. Don’t get swept up in the euphoria, keep your portfolio diversified where assets that perform well this year can buffer against those that aren’t performing well.
Slow and steady wins every time!