Taming Your Emotions: The Key to Better Investment Returns

A great man once said to use reason before passion. This could not possibly ring any truer than in the world of long-term investing. While emotions are very powerful tools that can be harnessed to help us unlock deeper potentials or connect with one another in new ways, they are less advantageous in the investing space.

When it comes to major money decisions, emotions can sidestep rationality and make the investment ship remarkably difficult to steer through market volatility. Frenzied media headlines and apprehension from other investors can trigger potentially harmful panic-mode emotions that cause investors to make costly—even life-changing—investment errors.

In this unprecedented time of global market upheaval due to the effects of the coronavirus pandemic, we have seen stocks take some swift and unexpected turns. At one point, economic shutdowns resulted in investor portfolio values dropping by as low as 30%. But, after the shortest bear market in history lasting only from February 2020 to April 2020, stocks rebounded in 2020 and 2021 to notch record highs for seven or more months in a row.

In times like these, especially, it’s no wonder investors are emotional. But, emotional decisions aren’t always the best ones. More often than not, taming your emotions is the key to better investment returns.

EMOTIONAL DECISIONS ARE NOT ALWAYS GOOD ONES

Responding emotionally to drops in the market can instigate impulsive and poor decision-making. So, taking a deep breath and applying caution before buying, selling, or reinvesting shares is vital to maintaining a healthy portfolio.

Investors who respond to rumors within the marketplace and act on their fear often end up watching dips and rebounds (like that of 2020) from the sidelines as their former investments settle and start to climb again. In the aftermath of such emotional hijacking, some may attempt to regain former ground by rebuying those same investments, but unfortunately, that seldom happens. You see, more often than not, investors have already missed out on the market’s best days by the time they gain the courage to enter back in.

How much do investors sacrifice for losing out on the best days? J.P. Morgan has put an exact price to these missed days in its Guide to Retirement report. If you invested $10,000 into the S&P 500 on Jan. 3, 2000 and left it completely invested until Dec. 31, 2019, you would've received an average annual return of just over 6%. Your $10,000 would've grown to $32,421.

This 20-year period of time includes roughly 5,000 days during which the stock market was open. But as the table below shows, if you missed just the 10 best days out of those 5,000, you'd have less than half as much money as you started with. Miss more than 20 winning days, and you'd have lost money!

Data source: JPMorgan.

YOU AREN’T THE ONLY ONE FEELING THIS WAY

This phenomenon is not uncommon. It’s easy to get caught up in the media hype, purchasing investments at peak periods and selling during the downturn of the market cycle. However, remaining disciplined and staying the course is a much more viable long-term strategy. In practice, proper asset allocation and diversification still remains the key to keeping investment returns more balanced, allowing for the best possible scenario in your portfolio.

BRACE FOR IMPACT OR STAY THE COURSE?

Investors who are able to manage their emotional response and stay committed to their portfolio strategy have remained, for the most part, untouched. For the most part, evidence-based investors have enjoyed hearty gains this past year and a half. Those who succumbed to their emotions, responding to media pressure and widespread fearmongering, however, may now be lagging.

RULED BY EMOTIONS? YOU’RE ONLY HUMAN

Why do even the savviest investors sabotage themselves through impulsive behavior during market fluctuations? Simple. We’re human. It’s instinctual. As a species, we are hard-wired to perceive danger. The fight and flight response is a normal and necessary function that aids in our survival.

At this point in history, on-demand access to information has made things much more difficult for emotional investors. Market results are monitored and delivered through the use of computers all day every day. Investing has become a challenging sport requiring almost instant judgment and global awareness. As investors, we must moderate our reactionary impulses and apply a more cool-headed response if we want to prevail.

EMOTIONAL BIASES EXPLAINED

Dalbar, Inc. has performed extensive studies on investor behavior and the effects that behavior can have on portfolio value. They have researched and uncovered how many of our own biases short-change us in the long-run. Here are a few examples.

Recency Bias

Recency bias occurs when an investor makes decisions based on recent events and doesn’t study the big picture. With markets in continuous fluctuation, understanding how a stock trend has behaved historically—not just currently—will lend much-needed insight into how the stock could perform in the future. As always, past performance is not indicative of future result; but, recent behavior does not predict future behavior, either.

Pattern Bias

Pattern bias refers to seeing a pattern where none exists. These patterns can appear obvious but are not real, and occasionally, they fool even the financial experts. Giving more weight to long-term trends and more diversified assets is a safer method than looking for a quick winner based on a false pattern trend.

Herd Mentality

We all know about herd mentality. When it comes to investing, we would all love to be in on the hot ticket or dump the rotten potato. When market shares plummet or soar irrationally, investors become influenced by what everyone else seems to be doing, making their decisions based on emotional response instead of logic, research, and facts.

Seeking evidence-based advice and peer-reviewed research help protect you from falling into the herd mentality trap.

AN ADVISOR CAN HELP YOU STAY THE COURSE

To invest without engaging emotion is very difficult, but taming these responses will lead to safer and more successful investing. So take a deep breath and listen to the voice of reason—as reason before passion is the key to achieving your financial investment goals.

And if you aren’t the best at talking yourself through these situations, that’s ok. You aren’t alone. And you don’t have to navigate this uncertainty in the dark. The Certified Financial Planner™ professionals at Northstar Financial Planning work to keep all our clients assured and in advantageous financial positioning in volatile and calm market conditions alike.

If you feel that you could benefit from this type of relationship, we would love to discuss the benefits of evidence-based investing with you. Contact us today for a complimentary Get Acquainted meeting. We look forward to meeting you.

Written by Rachel DeCarolis in collaboration with Lexicon Content Development