“You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets.” – Peter Lynch
No one can control the economy, the stock market or exactly know how an investment will perform in the short term. And that lack of control and certainly can lead to making poor (and many times, emotional) investing decisions – like chasing performance, not diversifying, or trying to time the market by moving into and out of the market (often at the wrong time).
While these reactions can be triggered by a desire to avoid risks (defined for our purposes as loss of capital), the results of these behaviors can pose the greatest risk of all — not reaching your long-term goals. In fact, the biggest risk may not be market fluctuations themselves; it’s our emotional reaction to these fluctuations and market volatility. That’s why it’s so important to have a financial advisor in your corner, helping you stay committed to your long term investment strategy.
Here are some common emotional investing behaviors that may derail your journey to reaching your long-term financial goals. By understanding the pitfalls of these behaviors, you can prevent making these investing mistakes in the future.
1. Heading to (or staying on) the sidelines
We’ve all seen the headlines: the economy’s slow recovery, the government’s budget deficit, market volatility. Prompted by what they perceive as bad news, some investors may try to “time the market” or sell investments just because of what they hear in the news – to move to the sidelines (and perceived safety) and wait until things get better. But it’s nearly impossible to correctly ‘time’ the market (predict when to get out and even more difficult to decide when to get back in), which often results in missing the best days – thereby severely affecting your performance And often, waiting until things get better means selling when prices are down and then buying back in when prices are higher – not a recipe for long-term success.
Other investors hold in too much cash because they want to avoid market risk. But not investing could actually increase your risk because you may not have enough growth in your portfolio to meet your short and long term financial goals or offset inflation (and loss of purchasing power).
2. Stay in the game and stay invested
Keep your focus on your long-term financial goals rather than on the ever-changing headlines, which could focus too much on the negative for dramatic effect.
If you begin to feel overwhelmed, talk with your financial advisor about your attitude toward risk and observe how you react to specific events. That way, you can work together to refine your goals and investment strategy, if needed.
3. Chasing performance
When the media raves about the latest “hot” investment or highlights “dramatic” declines in the market, some investors are tempted to chase the winners and sell the losers. This type of emotional response could be a recipe for underperformance because it results in buying high and selling low – not the recipe for a successful investment strategy.
4. Stay diversified
Having a diversified set of investments is more important than trying to find the next “hot” investment. When you have a portfolio made up of a variety of quality asset classes and investment types, success isn’t tied to one company or one type of investment. While diversification cannot guarantee a profit or protect against loss, it can help smooth out the ups and downs of the markets, providing the potential for a better long-term experience.
Financial experts recommend reviewing your portfolio with your financial advisor at least once a year to ensure it’s adequately diversified. Your financial advisor can also help you decide if a recent major lifestyle or goal change warrants a change to your strategy.
5. Focusing on the short term
Day-to-day fluctuations in an investment’s value may tempt some investors away from their long-term strategy. For example, some investors sold out in 2008 because their portfolio had fallen from an all-time high, even though their performance may still have been on track to meet their goals and well above where they initially started.
Decisions can also be influenced by how a situation is presented.
Take this example: “The Dow plummets 150 points” OR “the Dow declines 1%.” Both could describe the same situation, but the first sounds much worse. It’s these short-term movements, and how they’re presented by the financial entertainment media, that could lead you to make emotional short-term decisions.
6. Setting realistic expectations
Realizing that market declines, while unpleasant, are normal will help you set your own realistic expectations for investment performance. After all, the stock market averages one 10% correction every year, and over a 25-year retirement, you could experience an average of six to seven bear markets.
It’s important to measure performance as progress toward your long-term goals, not in day-to-day fluctuations. Your financial advisor can help you answer the question, “How am I doing?” and help provide the discipline you’ll need to stick with your long-term strategy and ignore short-term distractions.