Don’t invest in your emotions

We kid ourselves into thinking we can see future

I frequently observe that we are physical beings run by our emotions – the way we feel affects our actions.

That’s certainly true when it comes to investing, as historical data shows.

For the 20 years to December 2015, the S&P 500 Index – which tracks the stock market performance of the largest 500 companies in America – averaged returns of 9.85% a year.

You could simply leave your money to follow the combined ups and downs of those companies and it would double in value every eight years or so.

Yet during the same period, the average equity fund investor actually returned only 5.19% per year.

Why? Behaviour. How we behave when investing is often illogical, based on emotion rather than facts.

Let’s highlight that with some examples of the typical money-losing moves that average investors tend to make.

Buying high

Study after study shows that when the stock market goes up, investors put more money into it. When it goes down, they pull money out.

This is like going to the shops every time the price of something goes up, then returning your purchases when there’s a sale on, at a store that only gives you the sale price back.

We are human, so we overreact to good news and get greedy. We do the same with bad news and get fearful. Logic can easily go out of the window.

This tendency to overreact can become even greater during times of personal uncertainty, such as when we near retirement or when the economy is slumping – like during a pandemic.

We’re only human – good news makes us greedy, the bad makes us more fearful

Analysing effects

There’s an entire field of study which researches our tendency to make illogical financial decisions, called behavioural finance. It labels our money-losing mind tricks with terms like “recency bias” and “overconfidence”.

One study analysed trades from 10,000 clients at a brokerage firm, aiming to figure out whether frequent trading led to higher returns.

The results? The stocks purchased underperformed the stocks sold by 5% over one year and 8.6% over two years.

In other words, the more active the investor, the less money they made.

This study was repeated numerous times in multiple markets and the results were always the same. The authors concluded that traders are “basically paying fees to lose money”.

Overconfidence causes investors to exaggerate their ability at seeing where things are going. They are quick to use past data and to believe they have above-average skills that enable them to predict market movements. Almost invariably, they are wrong.

One of the best things you can do to protect yourself from your own natural tendency to make emotional decisions is to seek professional guidance and hire a Certified Financial Planner (see how at warrenshute.com).

A CFP can serve as an intermediary between you and your emotions – and, as we’ve seen, that can make a serious difference to your returns.

To learn more about successful investment, search online for The Money Planner podcast.