Better Investing by Managing Emotions
To say that the past two years, if not the past two weeks, of investing have been a rollercoaster would be an understatement. The S&P 500 is down about 10% so far in January 2022, and the market crashed over 10% in a single day in March 2020. While many investors sold out of their positions after that 10% drop, those who held on and continued investing were rewarded, heavily.
In just 354 days following the crash, the stock market surged back into a bull market and doubled in value. Those who sold at the bottom missed a rare opportunity, which demonstrates the importance of managing emotions in uncertain times. Some believe that you can remove emotion from decision-making, but we’re human. Everyone has emotions. The important part is learning how to manage them while managing your money.
We’re going to cover the challenges that come with the mixture of investing and emotions and how you can best manage your money in uncertain times to increase your chance of being a successful investor.
The Current State of Investing
The investing landscape looks much different than it did just a decade ago. With the rise of retail investing with apps, we can now trade stocks on our phones, and paired with social media, investing has become more of a social experience than an activity reserved for the wealthy. The “meme stock” phenomenon, as well as the growth of cryptocurrencies would seem to exemplify these changes.
Cryptocurrencies have captured the interest of many, even beyond the dedicated crypto community. Sharp increases have caused many investors to jump into the hottest new thing without fully evaluating and understanding the investment. We’ve seen cryptocurrencies earn incredible returns in a short period of time, only to come crashing back down as quickly as they went up.
Managing emotions during a period of growth is just as important as during a crash. Investors may shy away from investing in bull markets due to the belief that prices are too high and are bound to come back down. While it is true that the market can’t continue going up every day forever, trying to time market crashes to buy in at the bottom can be just as harmful to portfolio returns as panic selling, because of the missed growth.
Throw in decade-high inflation with a dollop of uncertainty around potential tax increases, and we’ve got an unfortunate recipe for emotional, reactive investing.
Challenges of Trying to Time the Market
Trying to time the market is like trying to win back-to-back roulette spins. The odds aren’t in your favor and trying to do so will most likely end up costing you money - not just in losses, but in opportunity cost.
Recent research* over a 20-year timeframe starting in January 2000 shows that the S&P 500 returned 6.06%. This period included 5,000 trading days. If you weren’t invested on the 10 best-performing days, the overall returns would drop down to 2.44%.
Missed the 20 best-performing days? .08% returns
Missed out on a month of the best-performing days? You’re now earning negative returns.
Investing Should Be Personal, Not Emotional
Managing emotions is challenging. Throw something like money into the equation, and it becomes even harder. Luckily, there are ways to reduce the emotional skin in the game and invest with confidence. First, it’s important to realize that you have your own goals, and you’re playing your own game when investing. The returns other investors are earning play no role in how your investments are performing.
But aside from the mental side of investing, there are strategies that can be used to reduce overall risk. Reducing risk will help keep emotions in check.
A Prudent, Risk-Focused Long-Term Plan
Understanding your ability to tolerate loss is critical to building an investment strategy. As we saw above, staying invested drives return. If the market drops and you panic-sell, you’re just crystalizing losses. Being honest about your tolerance for risk, or working with an advisor that has experience in building a risk profile can help you get to an asset allocation that is comfortable for you, even in extreme conditions.
Diversification is first up when it comes to allocating assets. By owning assets that react differently to the same market or economic situation, you create the potential for assets that are performing well to offset assets that are struggling. For example, when equities are up, bond prices may decline. Your asset allocation should match your goals and where you are in your financial journey.
It should be built for the long-term, to cover at least one market cycle – ten years is a good rule of thumb. As things change, it may make sense to shift and rotate your portfolio into different sectors to align short-term events. In our current situation of low interest rates and high inflation, many investors have turned to actively managing their fixed-income positions while looking for equities that have the power to pass price increases on to their customers.
Another way to reduce risk and manage emotions is by dollar-cost averaging (DCA). In this strategy, you invest the same amount of money each month regardless of how the market performs. The goal is to help you make consistent investments and avoid ill-timed decisions because you’re buying in at every price point.
But overall, it’s important to keep a few things in mind. Prior to adding risk to your money by putting it in the stock market, it’s generally recommended to have an emergency fund built to cover any unexpected expenses you may incur. It is just as important to have all high-interest debts paid off.
The Takeaway
Managing uncertainty and keeping emotions out of investing is easier said than done. It’s hard to remain level-headed and logical if you see your investments drop by 20%+ in a given period of time. But being aware of your financial situation, understanding the purpose behind your investments, and knowing that it’s impossible to completely avoid risk in the stock market will help you manage emotions and stay aligned with your overall investment strategy.
*J.P. Morgan
Pamela Chen is the Founder and Chief Investment Officer of Refresh Investments LLC, a fee-only financial planning and investment management firm located in Santa Monica, CA serving clients throughout the great Los Angeles area and the United States.
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