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Emotional Investing

by on August 05, 2018 5:00 AM

 

By Brittany N. Cox, Registered Investment Advisor at Nestlerode & Loy Investment Advisors

Market volatility causes many different emotions for investors, including fear, uncertainty and stress. The effect of a short-term decrease in your portfolio’s value can certainly increase your anxiety. This is a natural and understandable reaction. However, we can learn from this emotional experience.

There is no question that a person’s psyche affects rational thinking during times of stress that include money. The typical person is constantly receiving “investment information” from many sources including media, news and especially friends and coworkers. During a bull market when investments are doing well, there tends to be a stir of stories among peers concerning their successes with certain investments. This often leads to more people jumping into investments who were not invested previously. This stems from a bias referred to as “framing,” which describes an investor who selects an investment based on hearing how it performed from a friend or family member. The common issue with framing is that the investment may not be suitable for both parties.

Most investors do not realize that they are making unconscious financial decisions during these times. The study of behavioral finance is gaining more popularity as it analyzes the combined elements of economics and psychology. This describes some of the emotional pitfalls that are often associated with investing. One primary behavioral bias is overconfidence, which stems from the fact that people are not aware of what they do not know, causing them to be overconfident when making decisions that involve unforeseen outcomes. Also common with overconfidence behavior are hindsight bias and illusion of control. Hindsight bias leads an investor to make decisions about a future outcome based on previous related events. Illusion of control describes a person who believes that their ability was responsible for what previously happened, not chance or any external force.

As you can imagine, these emotional pitfalls can cause some havoc for an investor. Often, when looking back at this long running bull market, investors tend to believe that the gains and positive returns are a result of their skill. This tends to create a gradual move toward non-diversified portfolios as investors move their money to areas that they or their sources are having success with. As a result, when we reach a time of volatility, these investors may feel the consequences.

According to Morningstar, investor returns underperformed in relation to the funds’ returns over the past 10 years. There was a 2.49 percent gap in returns between the average investor and the fund at the end of 2013. This evidence suggests that emotional investing affects typical investors during periods of uncertainty.  One suggested strategy to eliminate some of the emotion from investing is dollar-cost averaging into an investors’ mutual funds. Dollar-cost averaging is when an investor invests an equal amount of funds over a predetermined period. For example, investing $50 per month into a fund for a period of 10 years, no matter what the market performance is. This means that during a downtrend, investors are purchasing shares at a lower price and during an uptrend those shares are earning capital gains and fewer new shares are being purchased at the higher price. This is a practice that could be used for employees while they are contributing to a 401k plan through their employer.

Another way to decrease the emotional response to market volatility is to have a well-diversified portfolio. Diversification can be achieved in many different aspects of a portfolio. An investor can diversify based on many factors such as geographies, industries or company size. Diversification can even be achieved based on the type of investment such as stocks, mutual funds, ETFs and REITs. Market conditions tend to favor a certain sector or subsector of the market, so being exposed to many is beneficial in times of volatility.

Because there are many emotional and behavioral biases to avoid when controlling your financial situation, it is important to consult with your trusted advisor about each of your financial decisions. Since these biases are unconscious or subconscious mental processes, they can be challenging to overcome. Goals-based planning can offer relief to these emotional pitfalls. Your advisor will help you work toward your goals and keep your focus on them. When you understand your financial situation and identify meaningful goals for your future, you are more readily able to work toward them.

 



Brittany Cox is a Registered Investment Advisor who works for Nestlerode & Loy, Inc., State College. She serves clients in Centre County and all of Pennsylvania as a fiduciary, fee-based advisor. She is a graduate of the Pennsylvania State University with a BA in business with a focus on financial services. Brittany enjoys working with clients for retirement and college planning. Brittany can be reached at [email protected]
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