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Avoiding Emotional Investing

Emotions and gut reactions often rule your investment decisions, which can be detrimental to your portfolio and your long-term investment goals. While feeling fear and panic can come naturally during volatile times, you can control how you react to these emotions.

We’ve heard the infamous investment advice from Warren Buffet – “Be fearful when others are greedy, and greedy when others are fearful.” However, for a lot of us, that’s easier said than done.

As humans, we look for certainty and naturally gravitate towards things that others find valuable. Unfortunately it is no different when it comes to investing. We are geared to follow the emotions of the crowd, which can lead investors to make impulsive decisions due to emotional investing.

Particularly in times of heightened volatility, a downfall in the value of investments can trigger an emotional response for many. Even risk-tolerant and sophisticated investors can fall prey to bias and irrational trading. Living in today’s hyper-connected world where media is so readily accessible, can also play a large role in fuelling these emotions, such as fear, panic, remorse or greed.

These emotions are common drivers in knee-jerk reactions to market fluctuations. For example, fear of pain from investment losses can lead to investors selling out of the market after a downturn. However, this often turns out to be a poor decision as it cements losses and reduces opportunities to participate in any future upswing corrections that could lead to better future returns. Conversely, fear of missing out (also referred to as ‘FOMO’) or overconfidence can prompt counterproductive performance-chasing.

This was illustrated during the global financial crisis, where many investors panicked and sold their investments, locking in their losses. Those who acted on emotion moved their money into cash or tried to time the market by reinvesting into the stock market shortly after. However, those who stayed on track with their long term goals and took advantage of high-quality assets on sale, benefited the most from the market upturn that came after.

Emotional biases can be hard to manage as they derive from impulse rather than miscalculation or interpretation of information. Investment decisions driven by these emotions can make it difficult to stay on track to achieve long-term financial goals.

Overcoming emotional investing

A 2018 study published in the Journal of Financial Planning1 found investor panic resulted in a loss of between 8 percent and 15 percent of assets over a 10 year period.

While it is not possible to wipe out the feeling of panic completely, you can control how you react to these emotions. There are some considerations that can help you make more logical decisions and keep you from chasing short-term gains or overselling in panic:

  • Tune out irrelevant information and noise, and resist the urge to follow the crowd. While it is good to have an overall understanding of what forces are driving bullish and bearish trends, following the headlines too closely and subsequently steering your investments solely on what you read or heard that day, can lead to poor decisions.

  • Think long term and acknowledge market downturns are temporary. While there may be 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. Profiting from short-term trading is a lot more difficult in practice than it seems.

  • Recognise your own risk tolerance as part of separating emotions from your investments. It is important to understand the risk return trade-offs that apply to various investments and select those that fit with your investment objectives and timeframe.

  • Develop a strategy that diversifies your investments across different asset classes and investment vehicles to minimise systemic and asset specific risk. Match your investments to your lifestyle objectives and make sure you hold adequate funds in low risk assets, as this can provide an element of protection when certain markets perform poorly. Remaining invested in a diversified portfolio for the long-term can help reduce emotional response to market volatility.

The bottom line

In times of market uncertainty, it is more important than ever to avoid emotion-fuelled investing and making investment decisions based on what others are doing. Remember to stay focused on the fundamentals and not let panic or overconfidence blind you. Movements in the market may make you uncomfortable or emotional, but if you have the discipline to stay the course, rather than fixating over monthly account statements, you are likely to feel better, avoid common investing mistakes and ultimately be better off in the long run.

Your financial adviser can help you steer through volatility, stick with your plan and understand how to proceed with your portfolio, based on your time horizon and risk tolerance.

 

For more on avoiding emotional investing, speak to your Morgan Stanley financial adviser or representative. Plus, more Ideas from Morgan Stanley's thought leaders.