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6 Ways to Prevent Emotional Investing That Can Devastate Your Returns

Individual investors usually underperform the market for a single reason: They let emotion influence their investing.

In bull markets, emotion takes the form of greed, of trying to get clever and outsmart other investors. In bear markets, emotional investing takes the form of panic-selling. Both ruin investors’ returns.

For example, financial analytics firm DALBAR found that in 2018, the average investor lost 9.42%. But the S&P 500 lost less than half that, at 4.38%. That year wasn’t a fluke — during the 20-year period from 1996 to 2015, they found the average investor earned only 5.19%, while the S&P 500 returned 9.85%.

Other studies show that emotion undermines the average investor’s returns. Removing emotion from investing practices helped investors earn up to 23% more over a 10-year period, according to a 2018 study published in the Journal of Financial Planning. Every study I’ve ever read on the topic draws the same conclusion: emotion is the enemy of investing.

Yet humans are herd animals, subject to herd psychology. When others panic, we panic and feel the urge to sell our investments before we “lose everything.” When things look rosy and others are buying in droves, we want to buy in too, not wanting to “miss out” on the market’s gains.

How do you combat these powerful emotional impulses that wreak such havoc on our returns?

It starts with a plan.

Creating Your Personal Core Investing Plan

Every time I’ve lost money in the stock market, it happened because I invested outside my core investing plan. Or, more accurately, before I developed my core investing plan.

Everyone should create their own core investing strategy and then automate it. Yours may look different from mine, and there’s nothing wrong with that. But it should reflect expert advice, whether from a human investment advisor or a robo-advisor (more on these shortly).

My core investing plan looks like this: I invest around 60% of my capital in stocks, all passively managed index funds. They comprise a mix of U.S. and international funds and a mix of small-, mid-, and large-cap funds. I invest in stocks primarily for long-term growth and diversification.

The other 40% of capital goes into real estate — some direct property ownership and some indirect forms of real estate investing. I invest in real estate for immediate passive income, for tax advantages, and as a hedge against inflation.

My stock investments are 100% automated from start to finish. That frees up time and energy for the real estate investments, which require more effort.

When stocks or real estate go up in value, I feel good about my net worth rising. When they go down in value, I still feel good about it — it means I get to buy assets “on sale.”

That doesn’t mean I don’t sometimes feel tempted to try to time the market. I know better than to do it, yet I feel the emotional pull to do it anyway. So I compromise by setting aside a little “play money.”

The “Play Money” Compromise

I set aside around 10% of my investing capital for experimental, rule-breaking, or fun and interesting investments. For example, a few months back, I invested a little money in cryptocurrencies. I acknowledged it was purely speculative and I had no real understanding of the forces impacting cryptocurrency valuation. And I did it anyway — with my play money.

I’ve experimentally bought into private REITs like Fundrise and Streitwise, using play money at first. The more consistency I see in these investments’ returns, the more I start incorporating these sorts of indirect real estate investments into my core strategy. Yet I started with play money to see how they operated.

I break my own rules and advice about not timing the market. Sometimes when stock markets experience a sudden, steep drop, I buy more index funds than my usual automated investments. But I do so with my 10% play money allocation, rather than changing up my core investing strategy.

If you enjoy active investing, day trading, or alternative investments, you don’t have to give them up entirely. To minimize the role of emotion and maximize your returns, try isolating your irregular investments to no more than 10% of your capital.


Steps to Combat Emotion in Investing

Forming your own core investing strategy is only half the battle. To ensure it actually happens, you have to commit implementing every step of the strategy you create. That largely means automating your money management.

Side effects of automating your money management include less time spent on your finances, less stress over money, higher returns, a higher savings rate, and greater wealth over time. If that all sounds good to you, implement the following steps once, and let your money fly on autopilot to remove emotion from your investments.

1. Automate Your Savings

Where do you get money to invest in the first place? By spending less and setting aside a hefty percentage of your income for investing.

I recommend creating a new budget from scratch because your old budget may include too many assumptions and financial baggage. For instance, if I asked you to simply tweak your existing budget, you probably wouldn’t even look at ways to reduce or eliminate your housing payment. You’d gloss over it as a nonnegotiable expense. Yet housing is the greatest expense in most of our budgets, and therefore offers the greatest room for savings.

Commit to setting aside a certain percentage of your after-tax income as your savings rate. These savings should be untouchable and your highest financial priority. You can do this by never letting this money sit in your checking account to tempt you.

Automate your savings so that money goes directly to your savings account, your brokerage account, or to paying off high-interest debt if that’s what you’re focusing on right now. You can do this through automated savings apps such as Acorns or Chime Bank, by splitting your direct deposit into several accounts, or by setting up automated transfers from your checking account to your savings account each payday.

Once you automate your savings, you don’t suffer the temptation to spend it. It never sits in your checking account; it goes straight to work for you.


2. Automate Your Investments

I invest in stocks through a robo-advisor, which not only invests my money automatically for me but also transfers the money from my checking account for me.

Robo-advisors have truly democratized investment advising, giving lower- and middle-income Americans access to expert advice and investment management. Many of the best robo-advisors are even free. Check out SoFi Invest and Charles Schwab for two good examples.

With a robo-advisor, you don’t have to lift a finger to invest. It all happens on autopilot in the background, week in and week out.

While that doesn’t prevent you from panic selling in a stock market correction or getting greedy in an aging bull market, it does mean you have to go out of your way to change your investments and let your emotions get the better of you.

But robo-advisors don’t just help you with automation. They also help you with three other key steps to reducing emotion in your investing: dollar-cost averaging, diversification, and automatic rebalancing.


3. Dollar-Cost Average

Although it sounds like a complex financial term, dollar-cost averaging refers to a simple practice.

Instead of making the mistake of trying to time the market, dollar-cost averaging refers to investing the same amount, at the same interval, in the same investments. Come rain or shine, bull market or bear, you stay the course with the same regularized investments.

It makes for one of the easiest ways to reduce risk in your stock portfolio. You don’t have to worry about whether now is a good time to invest; you just keep investing. Most commonly used with index funds, dollar-cost averaging means your returns mirror the index when averaged over time.

I set up my robo-advisor account to transfer the same amount every two weeks from my checking account. Once there, it’s automatically invested based on my asset allocation, which the robo-advisor proposed based on safe diversification for someone with my demographics and goals.


4. Diversify Your Investments

Trying to pick individual stocks is a dangerous game. Unless you’re a pro, I don’t recommend you pick stocks, at least not as part of your core investing strategy. If you must do it, do it with your play money.

I’ve been burned time and time again trying to pick stocks. Embarrassingly, in the early days of marijuana legalization, I tried to get clever by investing in a handful of pot stocks ahead of the curve. I lost nearly every cent I invested, partially due to widespread fraud in the industry and partially because I didn’t have the expertise needed to invest safely. I still get notices from the Justice Department asking if I want to participate in class action cases against some of those flash-in-the-pan startups that fraudulently inflated their stock prices before emptying their own money out.

What should you do instead? Diversify with index funds — U.S. and international, small-cap and large-cap funds, across a wide range of sectors.

Fortunately, you don’t have to pick these index funds yourself. When you sign up with a robo-advisor, they ask you to fill out a brief questionnaire about your goals, risk tolerance, and demographic details. They then propose a diversified asset allocation for you, which you can either approve or tweak.

Cliches like “don’t put all your eggs in one basket” exist for a reason. In this case, it’s tried-and-true financial advice.

But your ideal asset allocation isn’t static. It changes as you get older and near retirement, and your robo-advisor can help you adjust it as the years pass.

Even if your target asset allocation stays the same, your actual portfolio drifts depending on which investments do well and which underperform. That’s where rebalancing comes in.

Pro tip: You can also diversify your portfolio through established alternative investments. Companies like Masterworks allow you to invest in fine art, Vinovest gives you the chance to add wine to your portfolio, and AcreTrader can give you the chance to buy a stake in farmland.

Portfolio Management Asset Allocation Dollar Concept Diversify


5. Automate Your Rebalancing

Rebalancing your portfolio involves returning your portfolio to your target asset allocation, as your investments “drift” by changing in value over time.

Some investments inevitably outperform others in any given year. And it doesn’t sound so bad to let your money ride on the high performers, rather than selling some of them and reinvesting in underperformers. Once again, though, that’s the influence of emotion on your investments. You have a target asset allocation for a reason, and you should stick to it.

To begin with, it helps manage your risk. Stocks usually outperform bonds significantly, but that strong performance comes with a cost in volatility and risk.

Beyond risk management, you should also rebalance your portfolio for higher returns. Selling strong performing investments forces you to sell high. Moving money into investments that have underperformed recently forces you to buy low.

Sure, it feels better to let your winnings ride. But that’s is precisely why you don’t let emotion influence your investing strategy.


6. Avoid Retirement Fears Through Planning

Gone are the days of pensions and hefty Social Security checks. Among the many ways retirement has changed over the last generation, Americans have become far more responsible for planning their own retirement.

Yet the average American remains woefully unprepared for retirement, in both their finances and their fiscal knowledge. Many don’t understand retirement planning basics like safe withdrawal rates and sequence of returns risk. Many don’t know how much they should have saved for retirement at their age.

All of this makes them vulnerable in their retirement investing and particularly vulnerable to get-rich-quick schemes, shortcuts, and panic selling.

Form a detailed retirement investing plan with a financial advisor. Don’t feel obliged to hand over your investments to manage; many charge by the hour instead for frank and unbiased advice. Your robo-advisor can also help, although in this case, it’s worth talking through your plan with a human being.

That plan should include the following points:

  • How much do you need to save for retirement?
  • What asset allocation should you target each year between now and retirement, and then after you retire?
  • How much can you withdraw from your nest egg each year in retirement?

None of these are emotional questions. And nowhere in the answers should emotion play any role.

As a final thought, the general rule of thumb for calculating a safe withdrawal rate is to subtract your age from 100, 110, or 120, depending on your risk tolerance. The number you come up with is the percentage of your portfolio that should remain in stocks. The rest should go into lower-risk, income-oriented investments. If you have a low risk tolerance, you should use 100. If you have a higher risk tolerance, you should use 120.


Final Word

Herd psychology and emotion will ruin your returns if you give them the chance.

Buy low and sell high, they say. But that means buying when everyone else’s panic has driven prices lower and selling when everyone else’s greed has driven them higher. It means resisting the prevailing mood of the day and continuing to follow a predetermined strategy.

It doesn’t mean you should try to time the market. It means you should automate your savings and investments, stay the course, and resist the urge to intervene.

Do that, and you’ll see far better returns than the average investor, save time, and lower your financial stress.

How do you see emotions creep into your investing decisions? What steps do you plan to take to combat it?

You are being referred to SoFi Wealth, LLC’s website (“SoFi Invest”) by Money Crashers, LLC, a solicitor of SoFi Invest (“Solicitor”). The Solicitor that is directing you to this webpage will receive compensation from SoFi Invest if you enter into an advisory relationship or into a paying subscription for advisory services. Compensation to the Solicitor may be up to $50. You will not be charged any fee or incur any additional costs for being referred to SoFi Invest by the Solicitor. The Solicitor may promote and/or may advertise SoFi Invest’s investment adviser services and may offer independent analysis and reviews of SoFi Invest’s services. SoFi Invest and the Solicitor are not under common ownership or otherwise related entities. Additional information about SoFi Invest is contained in its Form ADV Part 2A available here.

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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