4 ways to avoid emotional investments costing you big
Emotional investing occurs when the decisions you make are driven by feelings such as your fear of losing money. These choices can cause you to sell investments at the wrong time, such as when they are trading at a low price.
In the long run, selling at the wrong time can reduce the return on your investments. Here’s how much this kind of action might have cost you in the past and how you can avoid it in the future.
The impact of emotional selling
At the turn of the century, when the dot-com bubble burst, an investment in large-cap stocks fell a total of 43.1% between 2000 and 2002. If you had started 2000 with $ 100,000, your account would have valued at $ 62,384 at the end of 2002.
In 2008, a $ 100,000 large-cap equity portfolio would have shrunk 37% to $ 63,000 due to the Great Recession. In March 2020, your accounts would have dropped 34% in less than a month due to fears of COVID-19. If you had invested $ 100,000 by then it would have fallen to $ 66,000. Investors who did not sell during these times were cured of the dot-com bubble in 2006; by 2012 with the Great Recession; and by July 2020 during the COVID-19 crisis. On the other hand, if you had sold your investments because of your fears, you would have realized those losses and missed the collections. Even if you had ultimately redeemed your investments, you might have bought them at a higher price than you sold them.
The growth forecasts for your returns are based on your long-term investment. The more you trade and exit, the more your returns can deteriorate. Avoiding these types of decisions and keeping your money invested is in your best interest. Here’s how you can make sure it happens.
Think long term
History has shown us that over long periods of time the stock market has consistently experienced positive growth. the S&P 500 is trading 199.7% more than 10 years ago. But this growth is not linear and there are years when you get positive returns, stable returns and even negative returns.
If you end up using your money in a year when you get a positive return, your accounts would have grown. In a flat year, you won’t be any worse than when you started. But in a year of negative returns, losing 37% of your account value could have held you back from an important goal like buying a new home.
If you are investing in more volatile securities like stocks, you should do so in your long-term accounts. This way, your accounts have plenty of time to recover from losses. This strategy might prevent you from making an emotional selling decision because you are worried that you might not reach a milestone you envisioned.
Have appropriate risk tolerances
Are you comfortable with volatility? An average rate of return of 19.97% on an investment in large cap stocks over the past 10 years is attractive but comes at a cost. This cost corresponds to larger losses during bear markets.
If the thought of losing nearly half of your wealth in the three years between 2000 and 2002 makes you nervous, investing only in large cap stocks may be too risky for you. Adding other investments, such as investment grade US bonds, can help balance this risk.
If you had a portfolio of 50% bonds and 50% stocks during that same period, your total losses would have been only 6.4% and your accounts would have gone from $ 100,000 to 91 $ 342. But you wouldn’t have made that much in the following years when the markets recovered. That’s why finding an asset allocation model in which you feel as comfortable with your downside risk as your upside potential is important to your long-term strategy.
Investing in a stock or type of investment can work very well for you or very bad depending on the year. And year after year, different investments will end up becoming the best performing, the worst performing, or somewhere in the middle. For example, in 2006, real estate investments returned 42.1%; in 2008, they lost 48.2%; and in 2013, they were gaining 3.7%.
Unfortunately, there is no way of knowing which year will result in which type of return. That’s why diversifying and owning a bit of everything is a great way to lower your overall risk and avoid getting caught up in the emotional ups and downs of a particular investment.
For an important event like retirement, you can reduce your exposure to stocks in your retirement accounts. But in a year like 2008, you could still experience a significant loss of 31.76% with a moderate portfolio of 50% bonds and 50% stocks. If you were to then take a 4% distribution, your accounts would be 35.8% smaller at the end of the year.
Having an emergency fund that will cover at least a year of your expenses in cash or cash equivalents may mean not having to liquidate securities for living expenses. Instead, you can leave that money invested and let it recoup losses while using your available cash to cover expenses.
Emotional investing can create a wedge between the ROIs you earn and the ROIs you thought you would win. These lower returns could take longer to achieve your goals. However, having the right time horizons, the right emergency fund, and well-diversified investments can help you improve your chances of achieving your goals whenever you want.