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Why Emotion Is the Enemy of Investing – How to Avoid Herd Psychology

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To paraphrase and expand on Dave Ramsey’s “Baby Steps”: Personal finance is not a math problem. It’s a behavior problem.

While Ramsey spoke in the context of debt management, the same applies to all personal finance and casual, passive forms of investing. Sure, expert investors dive deep into technical analysis, looking for that perfect predictor of market turns. But most of us don’t have a Ph.D. in economics and simply look for maximum returns with minimum time spent.

The good news: You can earn strong returns with completely automated investments.

The bad news: Your emotions fight you tooth and nail along the way, damaging your returns if you surrender to them.

A 2018 study published in the Journal of Financial Planning found that investors who use a behavior-modified approach to investing that removed emotion saw returns up to 23% higher over 10 years. Yet with more adults responsible for their own retirement planning than ever before, self-managed investing has become a critical life skill.

That means we all need to learn how to manage our financial emotions if we ever hope to retire.

Resisting Herd Psychology

Herd Psychology Philosophical Flock Sheep

You know the old trope: buy low and sell high. But apply logic to that for a moment: to do so successfully, it means buying when the herd is selling (driving prices lower), and selling when the herd is exuberant (driving prices higher).

Warren Buffett put it elegantly: “Be fearful when others are greedy, and greedy when others are fearful.”

Easier said than done. As herd animals, humans mirror the emotion of the crowd. It served us on the savannah — when the alarm went up about an incoming predator, communal fear kept all members of the community alive. But as with so many vestigial impulses, it doesn’t serve us today, at least not in investing.

The first step to separating emotions from your investments simply involves recognizing the risk. Acknowledge that you are a herd animal, like all of us, and therefore subject to powerful emotional impulses based on those around you. Then acknowledge that those emotions push you in the opposite direction of sound investing principles.


Emotions That Negatively Impact Sound Investing

Students Portraying Different Emotions Covering Face

In both winning and losing years for stocks, the average investor earns lower returns than the stock market at large. They underperform because they sell during downturns and only buy after the market shows a strong recent history of gains rather than investing consistently for the long term.

That’s emotional investing. Three primary emotions negatively impact your returns: fear, greed, and frustration or impatience.

Fear

Consider 2018, the last full-year analysis available from Dalbar, when the S&P 500 lost 4.38%. The financial analytics firm found that the average investor lost more than double that, at 9.42%. They lost money because they panic-sold when the market declined — they sold low.

For another illustration, look at the best buying opportunity in recent memory: the March lows of 2009. That trough offered investors an incredible opportunity to buy shares of large household names for pennies on the dollar. Companies like Bank of America, General Electric, and Wells Fargo were all trading in the single digits. Many of these companies went on to grow 500% or more over the following years.

Yet fear pushed many middle-class workers out of stocks entirely. Nearly two-thirds (63%) of Americans owned stocks in some form — including employer-sponsored plans like 401(k)s or SIMPLE IRAs — in the mid-2000s, according to a 2019 Gallup poll. After the Great Recession, that number dropped to roughly half of Americans.

Those who shied away from stocks missed out on the longest bull market in history, from 2009 to 2020. They let their fear get in the way of building wealth.

In contrast, the wealthy continued participating in the stock market. The wealthy think differently about money, and they leave their money invested long-term rather than panic-selling it.

Fear is the enemy of investing because it keeps you from taking advantage of rare “fire sale” opportunities. The best time to invest in an asset is when the herd panics and prices plummet.

Greed

The same logic applies to the buying side of the equation. Too many would-be investors sit on the sidelines in the early stages of market upturns out of fear then start seeing dollar signs as they watch the stock market climb.

After waiting for a track record of growth before they feel comfortable investing, suddenly, they see those gains and want in on it.

But by the time they witness enough growth to feel green with envy and greed, much of the bull market may have passed entirely. In fact, the best weeks and months of a recovery tend to be the first ones. In the first month after the S&P 500’s low in October 2002, it rose 15.1%. After the S&P 500’s low in March 2009, it leaped 26.6% over the next month.

Investors who waited for greed to drive them into the market missed out on much of the recovery.

In good markets and bad, the average investor underperforms the market itself. In the 20 years from 1996 to 2015, the S&P 500 generated an annualized return of 9.85%. Yet Dalbar found that the average investor earned roughly half that: 5.19%.

There’s an old saying on Wall Street that “bears make money, bulls make money, and pigs get slaughtered.” “Pigs” applies to the wafflers, the investors who invest based on the emotion of the herd.

Frustration or Impatience

Have you ever sold an investment because you felt frustrated by its performance only to see it surge after you did?

Anger and frustration can make you dump fundamentally sound investments just because you get tired of waiting for them to show progress. Yet overreacting in frustration and impatience often robs you of your best investments and ideas.

Granted, sometimes, new information comes to light that changes your fundamental analysis. By all means, stay flexible and don’t cling to bad investments out of stubbornness. But if the fundamentals for an investment remain sound, don’t dump it just because other investors haven’t noticed it yet.

Always remain calm in investing and business. As long as your underlying thesis for your investment hasn’t changed, neither should your emotions.


Strategies for Avoiding Emotional Investing & Maximizing Returns

Businessman In Office Analyzing Researching Strategizing Finances Return On Investment

Intellectually, you get it: Emotion hurts your returns. But that doesn’t make it easy to resist those emotions while in the grip of a stock market correction or bear market.

Avoiding emotional investing starts with a mindset shift. You must stop thinking of your investments as immediate assets and stop dwelling on the daily fluctuations in your net worth. Your investments, particularly stocks, will rise and fall, but in the long term, stock and real estate markets have always risen in value.

Take a long-term view of your wealth. Don’t think in terms of “I lost $20,000 in my stock portfolio today.” Think in terms of long-term averages and your long-term financial and lifestyle goals.

In that light, use these immediate tactics to help you build wealth faster and avoid emotional investing.

Invest by Dollar Cost Averaging

Smart people love opportunities to show off how smart they are. Unfortunately, when it comes to investing, that means trying to time the market.

Don’t do it. Seriously.

There are plenty of mathematical reasons and historical examples of why you shouldn’t time the market. The market isn’t rational, so even if you brought the perfect mathematical model to bear based on economic fundamentals, it still wouldn’t predict irrational human behavior.

Besides, tomorrow’s high or low may still be less attractive than today’s pricing. Market timers often end up waiting for an imagined “better moment” that never comes.

Instead, invest the same amount into the same investments at the same regular interval. It’s called dollar-cost averaging. It’s boring, and it works.

For example, you could open a Robinhood account and invest $500 in an index fund mirroring the S&P 500 every two weeks on your payday. Over time, your investment’s performance will reflect that of the index itself. That means your investments will roughly double the average investors’ returns, at least according to Dalbar’s research.

Keep it regular, and don’t try to get cute or fancy. No, you don’t get the benefit of bragging about how smart you are. Instead, you get higher returns and lower risk among your stock investments.

Automate Your Savings

Far too many people just save whatever they have leftover at the end of the month. That usually means less than they planned and often means nothing at all.

Don’t rely on discipline to save money. The surest way to boost your savings rate is to make your savings the first “expense” paid out of your checking account every single payday. It removes all temptation to spend that money and helps you trick yourself into saving more by pulling it out before you even see it in your account.

You can automate your savings in several ways. One option simply involves creating automated recurring transfers from your checking account to your savings account. Alternatively, you can use automated savings apps like Acorns or banking features like Chime Bank’s automated savings.

Or you can combine automated savings with automated investing through a robo-advisor.

Automate Your Investments

Like human investment advisors, there are pros and cons to robo-advisors. But they do several things really well, including proposing investments and then automating them for you.

Based on your personal details, goals, and risk tolerance, robo-advisors propose a series of investments appropriate for people like you. You can then set up automated recurring transfers to your robo-advisor account, and they handle buying, managing, and rebalancing your investments for you from there.

Today, some of the best robo-advisors don’t even charge for their services — at least not for the fully automated version. For example, SoFi Invest and Schwab Intelligent Portfolios are free.

Some robo-advisors like Vanguard Personal Advisor Services offer a human hybrid investing service, where you get access to human advisors as well. These tend to charge more, but they also provide far more flexibility and the advantage of talking through your questions with a human being.

Diversify Your Portfolio

You’ve heard the old proverb about not putting all your eggs in one basket. To illustrate that financially, I like the Enron example: Imagine that you invested 100% of your life savings in Enron back in the early 2000s.

To use a technical term, you’d be completely screwed.

Instead, spread your money among many different asset classes and different assets within each asset class. In stocks, that means buying thousands of different stocks in multiple continents and regions in different sectors and with different market caps. You can do it simply and cheaply with index funds.

I also like real estate, particularly for immediate passive income and tax advantages. You could buy rental properties directly, of course (and I do), but most people don’t have the interest in learning the skills needed to do so. Luckily, you have plenty of options to invest in real estate indirectly instead through companies like Fundrise. You could also invest in art with Masterworks or farmland through companies like AcreTrader.

The percentage you aim to invest in each asset class and each type of asset within each class is called your asset allocation. It doesn’t remain the same over time. Your ideal asset allocation changes as you get closer to retirement. But your asset allocation also drifts as some of your investments outperform others. That means you need a mechanism for reverting to your target asset allocation, known as rebalancing your portfolio.

Automatically Rebalance Your Portfolio

Imagine you invest in 80% stocks and 20% bonds in your portfolio. Over the next six months, your stocks perform well while your bonds perform poorly, resulting in your portfolio drifting to 85% stocks and 15% bonds. To return your portfolio to your target asset allocation, you must sell off some of your stocks and use the money to buy more bonds.

You can do this manually, of course. Or you can let a robo-advisor or human investment advisor handle it for you. Most robo-advisors offer automated rebalancing as a baseline feature.

And rebalancing is essential. Not only does it keep your portfolio appropriate to your personal needs, but it also boosts your returns and eliminates emotion from your investing. Rebalancing forces you to sell high and buy low. And when you automate it, you leave no room for emotional second-guessing.

Pro tip: If you’re currently investing in an IRA or 401(k), sign up for a free portfolio analysis from Blooom. After you connect your accounts, Blooom checks to make sure you have the proper asset allocation. They also look at how diversified your portfolio is and make sure you’re not paying too much in fees.

Mitigate Vulnerability in Retirement

While you’re working full time and investing money regularly, market downturns don’t impact your daily life. If anything, they help you — they present an opportunity to buy up assets while they’re “on sale.” You get to buy low, and you can ride out the downturn without selling a single asset.

Retirees don’t have that luxury. Most retirees must gradually sell off assets in their nest egg to pay their monthly expenses. The idea is that they slowly draw down their nest egg in retirement without running out of money before they die. In retirement planning, the speed at which you can draw down your assets is called a safe withdrawal rate. If you’ve heard of the 4% Rule, then you know the most famous example of a safe withdrawal rate.

But in market downturns, retirees’ assets suddenly become worth far less money. If you started with a million-dollar nest egg and planned to withdraw 4% per year ($40,000), then the market collapses by 30%, you now only have $700,000. Withdrawing $40,000 of that $700,000 means depleting your nest egg far faster than you’d planned.

Market crashes early in retirement present a particular problem for retirees. Known as sequence of returns risk, it turns out that a market crash early in retirement causes far more damage than an equivalent market crash later in your retirement. The more time your portfolio has to grow in a bull market after retiring, the more margin and buffer against losses it builds up.

Older adults need to be especially careful to avoid emotion in their investing as they approach retirement. Getting spooked and converting all their money to bonds can leave them without sufficient returns to keep their nest egg going for the rest of their lives. Conversely, getting greedy and leaving all their money in stocks leaves them vulnerable to a stock market crash.

As a rule of thumb, subtract your age from either 100, 110, or 120, depending on your risk tolerance (the lower the number you use, the more conservative). The resulting figure is the percentage of your portfolio you should leave in stocks. If you’re 60 and subtract your age from 110, that means you should have 50% of your portfolio in stocks.

But don’t rely solely on an oversimplified rule of thumb. Talk to a financial advisor to form a personalized retirement plan.


Final Word

Emotion may serve you well in your personal life, but it has no place in your investing decisions.

Data ranging from the 2018 Journal of Financial Planning study to the reports by Dalbar reinforce what investment advisors have been telling us all along. Check your emotions at the door before making any financial decisions, much less major ones involving thousands of dollars in assets.

Form an investing strategy based on your own unique goals and needs. Then automate it to continue operating regardless of the herd mentality of the moment.

How has emotion impacted your past investments? What do you plan to do moving forward to eliminate emotion from your investing?

G. Brian Davis
G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.

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