The Psychology of Investing

The old stock tip, “buy low, sell high,” sounds so easy; however, individuals find it hard to hold, let alone buy, through a downturn. To avoid discomfort, investors may sell for fear of further losses. Many studies show investing and emotion go hand in hand. I am getting many calls and emails from clients concerned about the markets and the economy.   

According to an article entitled “Cross-national evidence of a negativity bias in psychophysiological reactions to news,” by Stuart Soroka, Patrick Fournier and Lilach Nir in PNAS (Proceedings of the National Academy of Sciences), news coverage of current affairs is predominantly negative. This is because journalists want you to watch their newscast, buy their newspaper or follow their Twitter feed. The article goes on to say the average human is more physiologically activated by negative than by positive news.

How does negativity influence investing? Negativity bias describes an investor putting more weight on bad news than on good. People react to negative events more quickly and strongly due to evolution. Thus, the latest news headlines of the Russia-Ukraine War, the Federal Reserve making the biggest rate hike in 22 years and stock market downturn are causing investors’ heartburn  I have witnessed CNBC anchors calling a “plunge” in the market or a “market rout” when stock indices are down only 1%. 

The first step in not letting emotions run your portfolio is to put things into perspective. Don’t act immediately. The continuation of this advice is to read beyond the headlines or call or email your advisor to put things into perspective.

The second step to avoid selling at the wrong time is to be comfortable with the loss potential in your portfolios. When an advisor talks about risk tolerance, this is an important discussion. Once your risk tolerance and allocation are in place, it’s best to stay the course to meet your long-term goals. There is a reason you are invested in stocks and have a specific allocation. When things get tough, which is inevitable, keep your eye on the long-term plan and your goals.   

Long-term goals and planning are keys to keeping your head (and money) in a crisis. In most financial planning software, the program considers the risk in your retirement and market volatility. This means typically, even with a downturn, your retirement plans will still be successful, if they were when the markets were up.

Investing emotionally isn’t just limited to selling during a bear market. Irrational exuberance is when investors are confident that asset prices will continue to go up, regardless of valuation. In these instances, investors forget to diversify and pile into stock or even into specific sectors (remember the 1990’s technology bubble) without regard for the risk that they are taking on.  Even in good times, stick with your plan and allocation.  

With Robinhood (HOOD), Fidelity (privately-owned) and others offering quick trading and instant access to trading anywhere, it sounds perfect for an investor. However, overconfidence can lead to excessive or active trading. In a 1999 study (“The Courage of Misguided Convictions” by Brad M. Barber and Terrance Odean), the least active traders had annual portfolio returns of 18.5% versus the most active traders that only returned 11.4%. With negativity bias and overconfidence as two psychological barriers to good investing, having instant access to sell or buy without enough forethought could be damaging to your financial results.

There are many other biases and psychological “pitfalls” when investing, so stay diligent. It helps to work with a financial professional to not jump ship or jump in at the wrong times. This can make all the difference to your retirement or other financial goals.

Judy Loy is Registered Investment Advisor, ChFC®, RICP® and CEO of Nestlerode & Loy, Inc.

All investing is subject to risk, including possible loss of the money you invest. Nothing in this article should be construed as investment or retirement advice.  Always consult with a professional advisor and consider your risk tolerance and time to invest when making investment decisions. Review your personal situation with a professional before planning any gifting or estate planning.