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Psychology of Investing - Part 3: Removing Emotion from Investment Decisions

| July 25, 2014

Our 1st two writings tackled the importance of factoring risk tolerance into our investment strategies, along with some ways to determine what your true tolerance for risk really is. Now let’s turn our focus on how we can best ensure that emotion doesn’t affect our investment decisions in a detrimental way going forward. We all know that the number one goal of any investment entered into is to “buy low and sell high” (apologies for the obvious). But we should understand that from a psychological standpoint, we are often more inclined to “buy high and sell low”. Sounds ridiculous I know, but hear me out…..

Ever heard of anyone (hopefully not you) that “took a beating” during the dot com collapse and never recovered? How about someone that sold all of their investments toward the bottom in 2009, and never participated in the recovery that followed? These are two recent examples of how emotions – fear and greed – can be dangerously detrimental to achieving your long term financial goals. When everyone around you is making money hand-over-fist, it is natural to feel like you are “missing the boat” and want to get it on the gains (greed). And when things go the other way quickly, it is very difficult to not panic and hit the sell button (fear). Think back to those two periods and be honest – were you in a rush to sell stocks as they ran up in value during the 90s, or to buy stocks as they collapsed in 2008? Probably not, because it is always psychologically easier to buy after things have gone up and to sell after everything has collapsed – “buying high and selling low” instead of the other way around.

So, how do we stop our emotions from getting the best of us when it comes to investing? Here are some general guidelines that should prove helpful:

  1. So as not to be redundant on here, revisit parts 1 and 2 of this series - planning properly before you invest is immensely important.
  2. NEVER invest monies that are going to be needed in the short term - doing so is gambling rather than investing.
  3. Try to ignore anyone who brags about enormous returns during rapidly rising market environments.  If you are hearing about it, it is most often too late (if even truthful in the first place) - and they won't come to you bragging about their losses when the party ends!
  4. If your advisor is not calling you during difficult market times....find a new advisor!  At the very least, pick up the phone and call them - you need to be able to lean on your financial professionals when you are feeling nervous.
  5. In very volatile market environments, change the station on the TV and radio.  Remember, the media needs to sensationalize for ratings - they want their audience to stay fixated on volatility both up and down.  Find a mindless reality show to take your mind off of things.....these days, you don't have to look far to find one (I highly recommend "Wicked Tuna" - great show).

The most important thing to remember when emotions are creeping in is to stick with your game plan! This is the reason that proper planning before investing is so important. Along those lines, it is absolutely appropriate (in fact necessary) for your plan to be altered over time – just make sure that it is being done so based on changes with your personal circumstances rather than changes in the market environment. Of course, I am not at all saying that your investment portfolio should not react to changes in markets, interest rates, etc. - it should. But those changes should be for “academic” reasons and not “emotional” ones.

At this point, I must remind you that all opinions expressed in this writing are solely my own and do not necessarily reflect those of LPL Financial……the Wicked Tuna recommendation in particular.  This time, I was also asked to point out that investing involves risk, including loss of principal.  Kind of assumed that was the point of this whole series in the first place, but what do I know?

Most importantly, as always, thank you to all of our clients who have placed their trust and confidence in Round Hill Wealth Management.

Thanks for listening,