Emotional investing happens when the decisions you make are driven by feelings like your fear of losing money. These choices can cause you to sell investments at the wrong time such as when they are trading at a low price.
Over the long term, selling at the wrong time can drag down your investment returns. Here's how much this sort of action could have cost you in the past and how you can avoid it in the future.
The impact of emotional selling
At the beginning of the century, when the dot-com bubble burst, an investment in large-cap stocks decreased by a total of 43.1% between 2000 and 2002. If you started the year 2000 with $100,000, your account would've been worth $62,384 by the end of 2002.
In 2008, a $100,000 portfolio of large-cap stocks would've shrunk by 37% to $63,000 because of the Great Recession. In March 2020, your accounts would've dropped by 34% in less than a month due to fears of COVID-19. If you had $100,000 invested at this time, it would've declined to $66,000. Investors who didn't sell during these times were made whole from the dot-com bubble by 2006; by 2012 with the Great Recession; and by July 2020 during the COVID-19 crisis. On the other hand, if you had sold out of your investments because of your fears, you would've realized these losses and missed out on the recoveries. Even if you eventually bought your investments back, you would've possibly bought them at a higher price than you sold them at.
Predictions of how your returns could grow are based on your staying invested over the long term. The more you trade in and out, the more your returns can deteriorate. Avoiding these types of decisions and keeping your money invested are in your best interest. Here's how you can make sure that happens.
Think long term
History has shown us that over long periods of time, the stock market has consistently experienced positive growth. The S&P 500 is trading 199.7% higher than it did 10 years ago. But this growth is not linear, and there are years when you experience positive returns, flat returns, and even negative returns.
If you end up using your money in a year when you experience a positive return, your accounts would've grown. In a flat year, you will be no worse off than when you started. But in a year of negative returns, losing 37% of your account value could've prevented you from reaching an important goal like buying a new home.
If you are investing in more volatile securities like stocks, you should be doing it in your long-term accounts. That way, your accounts have plenty of time to regain losses. This strategy could potentially prevent you from making an emotional sell decision because you fear that you won't reach a milestone that you envisioned.
Have proper risk tolerances
How comfortable are you with volatility? An average rate of return of 19.97% from investing in large-cap stocks over the last 10 years is appealing but comes with a cost. That cost is bigger losses during bear markets.
If the thought of losing almost half of your wealth over the three years between 2000 and 2002 makes you nervous, then investing only in large-cap stocks may be too risky for you. Adding other investments like U.S. investment-grade bonds can help balance out this risk.
If you had a portfolio of 50% bonds and 50% stocks during this same time period, your total losses would've only been 6.4%, and your accounts would've shrunk from $100,000 to $91,342. But you wouldn't have earned as much in the following years when the markets recovered. That's why finding an asset allocation model in which you feel as comfortable with your downside risk as your upside potential is important for your long-term strategy.
Investing in one stock or type of investment can work out really well for you or very badly depending on the year. And from year to year, different investments will end up as best performers, worst performers, or somewhere in the middle. For example, in 2006, investments in real estate earned 42.1%; in 2008, they lost 48.2%; and in 2013, they earned 3.7%.
Unfortunately, there is no way of knowing which year will result in which type of returns. That's why diversifying and owning a little bit of everything is a great way to lower your overall risk and avoid getting caught up in the emotional highs and lows of one particular investment.
For an important event like retirement, you may reduce your stock exposure in your retirement accounts. But in a year like 2008, you could still suffer a significant loss of 31.76% with a moderate portfolio made up of 50% bonds and 50% stocks. If you were then to take a 4% distribution, your accounts would be 35.8% smaller at the end of the year.
Having an emergency fund that will cover at least a year of your expenses sitting in either cash or cash equivalents can mean not having to liquidate securities for living expenses. Instead, you can leave that money invested and let it recoup losses while using your available cash to cover expenses.
Emotional investing can create a gap between the investment returns that you do earn and the ones that you thought you would earn. These smaller returns could make meeting your goals take longer. However, having proper time horizons, an adequate emergency fund, and well-diversified investments can help improve your chances of reaching your goals when you want.
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