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Avoiding Emotional Investing Behaviors

| July 08, 2016
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Investing

Commentary:

 

Following the shock and uncertainty of Britain’s exit of the European Union, stocks staged a dramatic selloff over just two trading days only to be followed by an equally dramatic recovery.  As you can see from the one year chart of the S&P 500 below, the far right side of the chart shows the 500 largest stocks in the US flirting with highs set in May 2015.  It has been a long, choppy, sideways ride for the last 14 months.  Will stocks again reverse course to the downside?  Will we finally set new long awaited all-time highs?  Should an investor be selling – or buying at the current time?  What is an investor to do?

 

 

We have all heard that being an effective investor requires being unemotional, and focusing on long-term goals.  But what does that really mean to be unemotional?  What does it mean to focus on long-term goals?

 

First, investing can be emotional and it’s very difficult to separate emotions from investing.  Common emotions that I have seen or experienced over the years include:

 

  • Fear
  • Frustration
  • Anger
  • Impatience
  • Sadness
  • Worry
  • Disappointment
  • Hopeful
  • Relief
  • Excitement
  • Confidence
  • Euphoria

 

These emotions will typically repeat over any given market cycle as you can see from the chart below.

 

 

I believe that these emotions cause us to want to take actions which may be harmful such as:

 

  • Buy more
  • Sell everything
  • Change strategies
  • Change advisors

 

Take a look at the chart below from Blackrock and Dalbar that shows that the average investor is earning just 2.11% annually.  Why?  Two words: Investor behavior.  The study below uses the net aggregate of mutual fund sales, redemptions, and exchanges each month as a measure of investor behavior.

 

 

So when I think about investing in an unemotional fashion, I think about trying to erase or ignore emotions as a way of avoiding the harmful behaviors they can cause.  Unemotional investing then is not the opposite of the emotion words listed above, it is the absence of the words listed above.

 

  • If I feel fearful, I need to stop feeling fearful
  • If I feel frustrated, I need to stop feeling frustrated
  • If I feel impatient, I need to stop feeling impatient
  • And so on.

 

Effective investing involves discipline and tremendous patience.  Short term needs for money should be invested differently than long term goals.  Looking at the graphic below from JP Morgan, notice that cash and cash equivalents are usually more appropriate for short term needs in the next 3-6 months but not appropriate for long term goals.  Longer term goals of ten years or longer require a more growth oriented mix of investments because as market risk declines over longer holding periods, inflation risk increases over longer holding periods. 

 

Notice the 1 year annual total returns on the lower left hand side of this chart.  Stocks, as measured by the S&P 500 have historically returned as much as 47% in a year, but have lost as much as -39% in a single year.  Quantifying this in dollars, this means a $10,000 starting investment would have declined by $3,900 to just $6,100.

 

Over a 5 year period, the S&P 500 averaged as much as 28% per year during its best 5 year period since 1950, but lost as much as -3% per year during its worst five year period.  This means that if stocks are down -3% per year over 5 years, or -15% cumulative, this would be fairly normal by historical standards. 

 

Notice the best 10 year period is a positive 19% per year, but the worst 10 year period is a -1% annually for all 500 stocks.  It is only after a 20 year holding period, that the worst stock market average annual return turns positive.  This would require tremendous patience and discipline and trying to ignore or erase emotions like frustration, anger, and impatience as well as avoiding emotional behaviors such as selling everything, switching strategies, or switching advisors.  I believe that working with a trusted advisor can help you recognize and avoid emotional behaviors, develop a disciplined approach, and help you work towards your short, medium, and long term goals.

 

I appreciate your business and your patience as we navigate today’s markets!

 

 

Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.

All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. Past performance is not an indication or guarantee of future results.

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