For the twenty years ending 12/31/2015, the S&P 500 Index averaged 9.85% a year. Not a bad return. The average equity fund investor earned a market return of only 5.19% according to Delbar, Inc.
One reason could be that the average investor has a hard time controlling their emotions. Emotions not only dictate how we feel but also influence how we act.
People tend to pour money in when markets are high and pull out when markets are low. This is the exact opposite to the principle of making money in the stock market, which is to buy low and sell high. Now, while it is not possible to time the market perfectly, it is possible to make prudent decisions and look for opportunities.
Two types of emotions - fear and greed - can wreak havoc on your portfolio.
Fear is the enemy of investing! When markets trend down based on some news-driven story, people tend to overreact and want to go to cash immediately. Fear can lead to anxiety and ultimately to a feeling of depression. It may be wise to wait out the storm. Think about it, would you put a for sale sign on your home when housing prices are falling? The same applies with your investments. You may want to consider not selling everything in a downward pullback and instead, ride the waves a bit.
Another type of fear is the fear of missing out (FOMO) which can lead to greed. Being overconfident when markets are hitting all time highs can lead to irrational investing decisions and may cause you to mistake good timing for skill.
There is an inverse relationship between emotions and investment opportunities. This is known as the cycle of market emotions as shown below.
People tend to rationally believe that when the stock market goes up and up that it won’t last forever but irrationally believe when the stock market goes down that it will never go back up.
Here are a few tips to consider to help manage your emotions:
- Do nothing. Doing nothing is actually a form of taking action. If your financial goals have not changed and your portfolio is structured around those goals, then short term fluctuations in the markets shouldn’t matter.
- Don’t go in and out of the markets frequently. Gene Fama, Jr, a famous economist, once said “Your money is like a bar of soap. The more you handle it, the less you’ll have.”
- Consider not selling in a down market. If your funds are allocated with your goals in mind you may be best suited to wait out the short term fluctuations.
- Be disciplined. A disciplined approach to investing may deliver higher market returns. If you don't have discipline, you probably shouldn't be managing your own investments.
One thing you can do to protect yourself from your own natural tendency to make emotional decisions is to seek professional help and hire a financial advisor.
Keith Wilson, CLTC
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Securities and Advisory Services offered through LPL Financial, a Registered Investment Advisor. Member FINRA/SIPC.
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