The Potential Costs of Emotional Investing

If emotional investing is keeping you from reaching your financial goals, you’re not alone. Here’s how to keep your emotions and behavioral biases in check so you don’t get in the way of your own success.  

This month we officially entered bear market territory as the S&P 500 lost more than 20% of its value from its previous peak. As sky-high inflation persists and interest rates climb, many investors are panicking—and understandably so.

Enduring the ups and downs of the market can be challenging, even for the most seasoned investors. And while most of us know by now that staying the course is prudent—especially during periods of discomfort—doing so may be easier said than done.

Indeed, long-term investing requires an understanding of the markets and the external forces that impact various asset classes. But a successful investment strategy doesn’t depend on academic knowledge alone.

It also requires an awareness of our unconscious biases—not just as investors, but as human beings—and the discipline to keep them in check. Unfortunately, too many investors fall prey to their emotional impulses. As a result, they ultimately fall short of their financial goals.

Why We Invest Emotionally

Researcher Herbert Simon concluded that most people use heuristics—i.e., mental shortcuts—when making complex decisions. For example, hiring managers often rely on a candidate’s past work experience and academic degrees to determine if they’re qualified for a particular role. Yet in reality, a multitude of factors can influence whether someone is a good fit for a position.

Similarly, investors are prone to using mental shortcuts when making investment decisions. A common example is herd mentality, which explains why investors often buy into euphoria and sell into panic. Another is confirmation bias. This bias causes investors to seek information that reinforces their existing beliefs and ignore facts that challenge them.

The bottom line is that humans are hardwired to make emotionally driven decisions. As investors, failing to keep our emotions in check can lead us to act in ways that don’t support our financial goals.

Emotional Investing in Practice: The Cycle of Greed and Fear

Long-term investors may feel a variety of emotions when it comes to making investment decisions. Nevertheless, two primary emotions tend to motivate investor behavior over the course of a market cycle: greed and fear.

Greed and Chasing Returns

According to researchers from Stanford and Duke University, what investors fear most is the risk that they may underperform their peers. Moreover, the average investor will continue to invest with the crowd—even when they know an investment is overpriced—due to fear of missing out on subsequent gains. This type of emotional investing is often driven by greed. Which can be problematic in practice.

First, the financial media tends to highlight popular indexes like the Dow Jones Industrial Average, NASDAQ, or S&P 500 to represent “the market.” Indeed, these indexes may be reasonable proxies for the U.S. stock market in many cases.

However, most long-term investors own a diverse portfolio of investments across multiple asset classes. In years like 2021, these investors may wonder why their portfolios aren’t keeping up with “the market.”  They may even take on more risk than is wise. Thus leaving themselves open to outsized losses when the market eventually corrects.

Similarly, fear of missing out helps explain why bubbles occur. Former Fed chair Alan Greenspan coined the term “irrational exuberance” to describe why investors drive asset prices higher than their fundamentals justify. We saw this happen with tech stocks in the late 1990s, real estate in the mid-2000s, and “meme stocks” in early 2021.

Unfortunately, bubbles eventually burst. Unlucky investors must then accept their losses. In any event, greed can cause investors to take on more risk than their circumstances and objectives warrant.

Fear and Loss Aversion

The flip side of the emotional investing coin is the fear of loss. According to behavioral scientists Amos Tversky and Daniel Kahneman, the psychological impact of a financial loss is twice as powerful as a gain of the same magnitude. In behavioral finance, this concept is known as loss aversion.

Fear of loss can also be problematic for long-term investors. Perhaps the most obvious example is feeling the temptation to go to cash and abandon an otherwise sound investment plan when markets are in turmoil. As we wrote in a previous blog article, this type of market-timing typically causes investors to underperform over the long run.

On the other hand, fear of loss may lead some investors to take on too little risk, simply to avoid the pain of seeing temporary losses in their accounts. As a result, these investors may not own the right mix of investments to reach their long-term goals.

The Costs of Emotional Investing When It Comes to Your Financial Plans

Making investment decisions based on fear or greed may be satisfying in the short term. Unfortunately, emotional investing tends to be counterproductive to long-term financial plans. If you’re tempted to let your emotions take the wheel, first consider the potential costs.

#1: Buying High and Selling Low

Successful investors live by the mantra, “buy low, sell high.” Yet in practice, the average investor does just the opposite.

Dalbar’s annual Quantitative Analysis of Investor Behavior (QAIB) report repeatedly shows that investors are their own worst enemies. Across time horizons, investors tend to consistently underperform broad market benchmarks by wide margins, largely due to buying and selling at the wrong times.

The 2022 edition of the QAIB report shows that over the last 30 years through 2021, the average equity investor earned an annualized return of 7.13%. Meanwhile, the S&P 500 Index generated an annualized return of 10.65% over the same 30-year period.

Likewise, Morningstar’s Investor Return™, also known as a dollar-weighted return, measures how the average investor fared in a particular fund compared to the fund’s total return over a given period. In 2021, Morningstar determined that in the 10 years through December 31, 2020, the average fund investor underperformed their fund investments by 1.7% annually.

As long-term investors, the goal isn’t to time entry and exit points perfectly. However, research shows that when investors let their emotions drive buy and sell decisions, they tend to underperform both the broad market and the funds they own.

#2: Missing Out on Market Rebounds

In many cases, emotional investing and attempting to time the market result in similar outcomes. This is especially true when the fear of loss causes investors to go to cash in a moment of panic.

Indeed, market-timing requires getting two decisions right. Knowing when to get out of the market, and knowing when to get back in. The problem is that even if an investor limits their losses by exiting the market during a downturn, they rarely reinvest in time to enjoy all of the subsequent rebound.

Recent research from PGIM Investments shows that while the duration and magnitude of bear markets vary, historically, they share one commonality. The recovery in the first year tends to be significant.

For example, the S&P 500 Index lost 56% from peak to trough during the Global Financial Crisis. However, in the year following the market’s bottom, the S&P 500 gained 69%. Although the longest bull market in history followed, those who were late getting back in the market would have missed a significant runup in returns.

Similarly, the S&P 500 dropped 34% from peak to trough at the beginning of the Covid-19 pandemic as a worldwide health crisis disrupted global markets. But the bear market was surprisingly short-lived, lasting only 33 days. The S&P 500 subsequently gained 75% over the next year.

#3: Falling Short of Your Financial Goals

The previous two costs of emotional investing are primarily focused on investment performance relative to a market-driven benchmark. Naturally, you may be wondering what these costs mean for you and your financial plans. Perhaps the most personal drawback of investing emotionally is ultimately falling short of your financial goals.

If you work with a wealth manager or financial planner, they’ve designed your investment strategy to help you reach future goals like buying your first home or retiring successfully. When you deviate from this plan, you’re likely undoing years of progress towards your life’s goals.

Unfortunately, this may mean scaling back your dream home or pushing back retirement several years. While these consequences can feel abstract now, they can have a very real impact on your finances and quality of life down the road.

Follow These Principles to Avoid Emotional Investing

If you’ve let your emotions get the better of you in the past, don’t despair. Keeping your emotions in check is challenging—especially when it comes to your money. The good news is there are steps you can take to avoid the pitfalls of emotional investing.

First, be sure to set clear and realistic financial goals. While it’s okay to aim high, aiming too high can lead you to take on too much risk in order to close the gap between where you are now and where you want to be.

In addition, don’t let market activity change your investment approach. Instead, focus on the things you can control—for example, your asset allocation, your savings habits, and your retirement plan contributions.

And when it comes to investing, make sure your portfolio is diversified across asset classes, investment styles, and markets. This may help smooth the ride over time as markets fluctuate.

Lastly, consider working with a trustworthy financial advisor who can help you develop a long-term investment plan that aligns with your risk tolerance and goals. Your advisor can also help you stay the course when your emotions get the best of you.

SageMint Wealth works with high-net-worth individuals, families, and business owners. We also have a passion for supporting women, the LGBTQ+ community, and individuals in the technology space. If we can help you develop a financial and investment plan that supports your lifestyle and goals, please contact us. We’d love to hear from you.