In Part 1 of this two-part blog series, we examined why investors are hardwired for emotional investing. In Part 2, we’re sharing some of the potential costs of investing emotionally—and how you can avoid them.
Consider the costs of investing emotionally when it comes to your long-term financial plan:
Cost #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 consistently 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.
For example, over the last 30 years through 2021, the average equity investor earned an annualized return of 7.13%. This compares to an annualized return of 10.65% for the S&P 500 over the same period.
Similarly, in the 10 years through December 31, 2020, the average fund investor underperformed their fund investments by 1.7% annually, according to Morningstar. In other words, investing emotionally can cause investors to sabotage their own performance—more so than the investments they own.
Cost #2: Missing Out on Market Rebounds
In many cases, investing emotionally and attempting to time the market lead to similar outcomes.
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 dropped 34% from peak to trough at the beginning of the Covid-19 pandemic, causing many investors to panic. Yet the bear market was surprisingly short-lived, lasting only 33 days.
The S&P 500 subsequently gained 75% over the next year. Meanwhile, investors who exited the market locked in their losses.
#3: Falling Short of Your Financial Goals Due to Investing Emotionally
Perhaps the most personal drawback of investing emotionally is ultimately falling short of your financial goals.
Indeed, a wealth manager or financial planner should design 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. These consequences may feel abstract now. However, they can have a very real impact on your financial wellbeing and quality of life down the road.
Follow These Principles to Avoid Investing Emotionally
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 investing emotionally.
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 trusted financial advisor who can help you develop a long-term investment plan that’s aligned with your risk tolerance and goals. Your advisor can also help you stay the course when your emotions get the best of you.
To learn more about the potential benefits of working with a trusted financial advisor, please contact us. We’d love to hear from you.