Emotional Investing

On 09/21/2011, in Investment Strategies, by Jordan Wilson

Investment markets have resembled roller coasters in recent times.

Up, down, sideways, making many investors sick to their stomaches.

While investing is an emotional experience at any time, this turbulent period makes things even worse for lots of investors.

So what should you do? 

Avoid Emotional Investing!

Emotional investing should be avoided.

Easy to say, difficult to adhere to. It is extremely tough to maintain a level head when your savings are at stake.

George Loewenstein, professor of both economics and psychology at Carnegie Mellon, discusses emotions and investing in this CNNMoney interview. It is well worth a read.

I think that if you can identify areas where emotions may take over from rational investment practices, you can watch out for these potential traps and try to limit their impact.

Plan When Times are Calm

As Dr. Loewenstein states, it is “dangerous to make long-term decisions based on short-term emotions.” You need to develop a fundamentally sound investment approach on which to make your decisions.

This approach should include short, medium, and long-term investment objectives.

It should also provide guidance for dealing with future investing issues (e.g., investment bubbles, bear markets, inflation) before they actually arise. It is always easier to determine a logical course before a crisis erupts.

Stay Focussed During Volatile Markets

To counter emotional investing problems, Dr. Loewenstein suggests using a professional advisor. Preferably someone that understands the ups and downs of the markets and can advise in a rational manner.

I would also suggest using some tools that we have previously discussed.

Develop a written Investment Policy Statement (IPS) when you begin to invest. Your IPS will be the framework with which you invest. It will also keep you on the correct path and help you avoid making investment decisions based simply on short-term emotional factors.

Utilize prudent risk management techniques. Key among these are portfolio diversification with attention to asset correlations and proper asset allocation for your investor profile.

Use common sense to identify potential investment bubbles and do not get greedy with unrealized gains.

There is no evidence that investors successfully time market volatility over the long run. So invest in a diversified, low-cost investment portfolio using a buy and hold strategy. For those who say buy and hold does not work in volatile markets, I disagree to some extent.

When managing your portfolio, employ dollar cost averaging to take advantage of market dips and to reduce acquisitions when markets are potentially becoming overheated.

It also means that you should review your portfolio on a periodic and consistent basis. Do not wait until the wolf is at the door before assessing your investment holdings.

If your objective, non-emotional review indicates rebalancing is required, feel free to do so. This can be done by reallocating existing holdings, adjusting future investment allocations, or through profit-taking.

Following a well-designed investment framework and strategy as outlined in your IPS will help you keep calm when the markets are volatile. Put in the effort to develop a sound IPS when starting out on your investing path. If you do, you will be rewarded over your lifetime by (hopefully) solid portfolio performance and a less stressful investment life.

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