The Danger of Emotional Investing

As human beings, we have the ability to do research, diversify our portfolios, and think things through, so why is it that people are underperforming the stock market by so much? The answer is emotional investment behavior. Individual investors are simply too emotional to outperform the stock market.
10/19/2016 03:29pm ET | Updated October 20, 2017
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Over a 30-year period, the average investor has made 3.79% on an average annual basis, while the stock market has annualized 11.06%. As human beings, we have the ability to do research, diversify our portfolios, and think things through, so why is it that people are underperforming the stock market by so much? The answer is emotional investment behavior. Individual investors are simply too emotional to outperform the stock market.

One of the most popular quotes about markets and emotions is by Sir John Templeton.

"Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria."

He explains that our emotions in relation to the stock market are always wrong. Bull markets emerge when we are most fearful, grow when we are scared and crash when we feel they never will.

The biggest problem with investing emotionally is that the way investors feel about the market is highly correlated with market performance at that time. This means that if the market is at a low, investors feel despondent, and when the market is at a high, investors feel euphoric. Poor investment behavior is either caused by a fear of loss, or overconfidence.

Have you ever been in a moment, and felt that you will never be able to move past that moment? That is the way investors feel when their investments plummet. Nothing and no one can convince them otherwise, even though stock market lows are generally the best time to invest. When investors trade based on their emotions during these times, they will inevitably be wrong. If you are feeling despondent, it is likely that you will sell, in fear that the market will never come back around again, but the reality is that our biggest rallies have occurred when investors are sad and fearful. The same goes for market highs. When the market is rallying, it is hard to see a world where the market goes down, so investors tend to invest the most at these highs, even though markets at all-time highs will ultimately have a correction. Adding to this problem is the media. The media feeds investors an incredible amount of information very quickly, encouraging investors to make emotional decisions based on current news. The internet has gotten us used to getting what we want, in the exact moment that we want it.

As an investor, it is important to arm yourself with the knowledge to get out of the emotional investing trap. Investors need to accept the fact that they cannot time the market, and that anyone that tries to convince them otherwise is wrong. The stock market is often inefficient, and is not always priced consistently with economic performance. While it is possible to understand overall trends and market movements, capturing that performance at precisely the right time is very difficult. You may turn to the experts for advice on market timing, but sadly, they don't know the answer either. For example, John Paulson made a killing in 2008 when he shorted the housing market, but his fund is down over 50% since 2010. His theories may have been right, and still may ultimately pan out, but his timing was wrong.

Bull markets have often emerged when investors least expect it, and there is no single formula for the start or continuation of a bull market. They have begun during recessions, expansions, and at all levels of rates. Up markets last longer than down markets, averaging 43 months, while down markets average 14 month periods. The average cumulative return for a bull market is 117.3% and average annual loss in a bear market is 24.6%.

Markets always recover; even after a disaster. One month after the collapse of Lehman Brothers, the biggest bankruptcy in history, the market recovered by 18.3%. By one year later, the market had recovered by 48.8%. After the September 11th terrorist attacks, the market made a full recovery after 1 month. After the Pearl Harbor attacks, the market recovered by 15% within one year. Most recently, the UK announced their exit from the European Union, causing the S&P to sink by almost 3% in one day. The market has recovered by 6% since the bottom of the Brexit crisis.

Another way to stay on track with your overall financial goals is to hire a financial advisor, and give them discretion to make wise and long term choices for your portfolio. Make sure it is someone that you trust and agree with their overall investment philosophy. Agree on a detailed long term plan, but allow them to implement it on your behalf. Commit to staying invested for a long period of time. Remember that you have no control over market timing, and neither does your advisor, but you do have control over the amount of time spent in the market. Generally, the longer you are invested, the more money you will make.

The best time to invest is when it doesn't feel so good. No big accomplishment feels very good when we are training for it. In order to lose weight, you need to cut out delicious food and work out harder than your body is comfortable with, but if you follow the uncomfortable path, you will ultimately yield your goal result. The same is said for investing. It will never feel good to invest. If the market is up, it will feel too expensive, and if the market is down, you will feel like it may never turn. If you can take the emotions out of the picture and stay invested for a long period of time, you will likely come out on top.

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