Have you ever looked back at your investment track record and thought about how stupid an investment was?
I know I have.
Investing is an emotional game, and it can lead us to make some terrible financial decisions when we let our emotions get involved.
That’s why we need to put systems and rules in place before we invest to help us avoid this nonsense. Which is what I’ll cover in this article.
Before we dive any deeper, I want to make something clear. As with any decision in life (especially financial ones), there are a ton of emotions that can become involved with investing.
I know you’re not a robot–so read through the below advice and take what works for you. Adapt and adjust your current philosophy on investing. There’s no perfect approach, but the more you can start to take emotions out of your financial decisions, the better chance you have of being successful. Now let’s start with first identifying your goals.
Table of Contents:
Before you start investing, you need to take some time to think about what your long-term goals are. Now, this is different than a long-term investing strategy. You can buy and sell stocks with a short-term mindset (which I don’t recommend personally) and still have a long-term plan in place.
Without an iron-clad long-term vision of where you’d like to go with your money, you’re basically throwing darts at a dartboard with a blindfold on (and depending on how bad you are at investing, you may have even had a few beers in you before throwing those darts). Like one of my favorite quotes from Alice’s Adventures in Wonderland says, if you don’t know where you’re going, it doesn’t matter which path you take (I’m paraphrasing, of course).
So here’s what you need to do:
Think About Why You’re Investing
Most of us will be investing to plan for retirement, but you might have enough cash on hand to want to play around in the stock market a bit. If that’s you–you may have vastly different long-term goals than someone who’s planning for retirement (or no goals at all). Figure out why you’re investing first.
Consider Your Age and Investment Horizon
Are you on the “back nine” of your career? If so, your investment horizon is much shorter, and you should be focused on stabilizing your portfolio and gearing up for retirement. If you’re fresh out of college, however, you can open the risk floodgates.
Determine What You Want Out of Life
Do you want to work until you die? Some people do, and that will change how you approach your investment philosophy. But most of us don’t. Most of us want to get out of the rat race early and do what we love. So figure out what that means to you. Do you want to live with your spouse in a small beach home? Do you want to be mobile and live out of an Airstream trailer? You need to decide at least the direction of where you’re going so you can plan for it. Living on the beach is much more costly than building a tiny home on a plot of land in Wyoming (in most cases).
Once you’ve answered these basic questions, you should have a sense as to what your long-term financial goals are (i.e., save up enough to retire to the beach or pay for a land plot and tiny home in cash).
Now I want you to write those goals down somewhere. Not type them in a Word document or your iPhone notes–write them down. I don’t care if it’s scrap paper or a beautiful Moleskine notebook–write them down. Trust me; there’s science behind this.
Tuck those goals away somewhere safe–a drawer, your wallet, or pinned to your refrigerator. Use it as a reminder and barometer for the upcoming investment decisions you’ll be making.
Now that you’ve written down your goals, one of two things will most likely end up happening. You’ll either become overconfident or underconfident in your investment approach.
In Jonathan Burton’s book, Investment Titans, he gives an example of overconfidence that I think makes this point. He says that if you ask a group of people if they feel like they’re better than average at getting along with others, about 90 percent of them will say they are. He then uses the same approach in asking people if they’re better than average drivers. In most cases, nearly everyone will say they’re better than average–which can’t be true if you consider our society. This leads to believe that many of us are overconfident when it comes to things–including investing.
If you’re overconfident, it can lead to poor investment decisions quickly. For example, you might think you know “more than the average amount” about a certain industry or stock than other people and ignore the red flags of a risky investment. Then a few months later you’re struck with awe when the stock tanks. You can also become overly confident about your expected rate of return, leading to disappointment and even more emotionally-charged decisions (i.e., you didn’t get the 15% you’d expected, so you make several more risky decisions to make up for it).
On the flip side, you can become underconfident with investing. Typically this happens when you’ve had a bad experience with investing (more on this below) or set unrealistic expectations for yourself that you can never meet. For example, there’s no way the average person can know everything possible about investing or about a specific company.
I worked for an equity research firm where analysts dedicated their entire lives to a specific industry and only a few companies within that industry. My team covered the steel industry, and we knew almost everything that was happening in the industry, but only focused on a handful of companies within that industry. That was more than enough work because you learn every intricate detail about the company–simply because you have to.
So recognize that you’re never going to know everything you can about a company, fund, or industry. Sometimes you have to just make a decision based on the information you have, and that’s the best you can do. If you become too underconfident, it will cause you to overthink decisions, and you’ll end up missing out on significant investment opportunities.
Find the Right Balance
The trick here is to find a balance between overconfidence and underconfidence. I guess that would mean just being confident in your decisions. Another way of thinking about this is being comfortable with your decisions. If you can make an investment decision and not have to think twice about it or second guess yourself, you’re beating underconfidence. If you can do this on a continuous basis, it means you’re making informed and objective decisions and beating overconfidence.
Diversifying your portfolio is a necessity for any smart investor, but when it comes to emotional investing it can play a different role. Having a portfolio that’s balanced and diversified in many areas can inadvertently prevent you from making rash decisions in a number of ways.
First, many of us make emotional investment decisions by lacking diversity in our portfolio. You know, the new (or overconfident) investor who keeps just one fund or one major stock (*cough* Google *cough*) in their portfolio thinking they have all they need, only to find out that one major shift in the market puts them in a bad position. They immediately switch their investment allocation to reflect what they think is a diversified portfolio and don’t consider things like market timing, the cost of the funds they purchase, or whether the stock they bought pays a dividend (note: I have a huge bias toward value investing).
Second, having a fully diversified portfolio, especially one with index and mutual funds, will reduce your desire to want to “tinker” around with your portfolio. Tinkering is good–don’t get me wrong–but it needs to be strategic (I’d call this strategic rebalancing). Tinkering is bad when you buy and sell funds or individual stocks on a consistent basis to try and reach some perfect balance of diversification. It’ll never happen. This can cause not only huge financial losses but also massive amounts of frustration and anxiety about investing.
So mix up your assets between individual stocks and different types of funds. Pick a diversification strategy that works for you (no, 90% in large-cap value stocks isn’t for everyone) and roll with it. Because you’ve found a balance in your confidence level (see, you knew that’d come back), you can be assured that your portfolio is diversified and you can focus on other things until the time comes when you need to make an informed decision about your portfolio.
Have you ever heard a sports analyst say something like, they’re not playing to win, they’re playing not to lose? If not, it’s a common sports expression when a team is playing overly conservative. You hear it a lot in football when teams aren’t being aggressive in going after the opposing quarterback and are instead playing everything safe. Sometimes this strategy works, but more often than not you can see the team is trying not to lose.
Instead, they should shift their focus toward winning. And you should do the same with your investment strategy.
The moment you begin to invest as if you’re “trying not to lose,” you become an emotional investor (and an overly-safe one at that–which isn’t a good thing). This goes in line with finding a balance in your confidence level, but you should be playing to win when you’re investing. You should be proactive and aggressive when you need to be–not overly safe.
This means you should immediately get rid of your fear of losing. In sports, losing might mean not getting a shot at the championship, at its worst. At its best, they might become a mediocre or even a playoff-caliber team. But not necessarily a championship team
If you’re constantly afraid of losing, you’ll never take risks with your investments. Without risks, you are never going to give yourself (or your money) a chance to grow. You have to take on risk if you want to be even remotely successful at investing.
The difference lies in your level of risk tolerance. You can still play to win without buying up the riskiest investments out there. You should still be doing research and doing your homework, but you should not shy away from downside risk. Every investment has some level of risk to it, and I want to encourage you to expand your risk tolerance a bit.
Taking losses within your portfolio is okay. It’s okay for an investment to strike out completely. This does happen. And this will happen to you–and even the best investors. That’s why you make objective decisions and diversify your portfolio–so you can hedge these risks with stocks you’ve gained on. For every 10% loss you have, you may have a stock that gains 15%, and you net a 5% gain. You won’t give yourself this opportunity if you play it overly safe. Sorry to rant here–but I’ve seen too many people miss out on big upswings in the market because they are too afraid of losing their investment–even delaying their retirement in doing so.
Reacting to major news in the stock market is easy. This is where most of us begin making emotional investment decisions. The news causes us to react both positively and negatively, and it directly correlates to our investment decisions.
Data shows that from 1997 to 2016, the average U.S. investor performed about 70% worse than the rate of return on the S&P 500. This data says that the average investor gained about 2.3% in annualized returns, versus the 7.7% annualized return of the S&P 500. Now, there are a lot of factors at play here, but this gap is significant. This would lead us to believe that the average U.S. investor, who is controlling his or her investments, is making decisions that cause him or her to perform worse than an index. Meaning, if that same investor had just stuck that money in a fund that mirrors the S&P 500, they’d have improved their gains by over 70%.
So why is there a big gap?
Again, many factors come into play here, but one major factor is the judgment of the investor. When we react to news, we tend to make uninformed and uneducated investment decisions, which lead to financial losses over time. An index isn’t making any decisions–it simply follows a set number of stocks. An index fund is the same, it mirrors a certain index and doesn’t have the risk of making emotionally-charged decisions.
No, this doesn’t mean you should put everything you have in index funds. It means you should avoid reacting to the news you see about the market or specific stocks/funds you own. Instead, use this news as part of a bigger decision. Use it as one minor data point in a plethora of other data points around an investment decision.
A fun (if not wild) example of how this could happen
Disclaimer: this is not a real situation that has happened–this is just an example.
Let’s say you’ve invested in Apple. You’ve done a ton of research about the company, it’s leadership team, and its financials and you’re very comfortable with the fact you’ve invested $20,000 in Apple stock. You keep up with the quarterly and annual financial statements and follow Apple in the media regularly. You’ve crafted a long-term buy-and-hold strategy for your Apple stock.
Then, suddenly you see breaking news one morning that says Apple CEO Tim Cook routinely takes trips to foreign countries to do drugs so he can have “visions” about where he should take the company (by the way, Onnit CEO Aubrey Marcus does stuff like this and, while incredibly controversial, he and his company are wildly successful). You check the ticker and see that Apple is trading down to the tune of 5% already. Thinking the CEO of the company you’ve just invested 20 large in is a nut, you instantly react to the news and sell your entire investment, happy that you got out only losing 5%. Your worry of Tim Cook bringing the company down with these unorthodox antics is now at rest since you’ve sold your stock.
Months later, you start to see news come out that what Tim Cook was doing was technically not a drug but more of a hallucinogen. You read that he went on an excursion once with Onnit CEO Aubrey Marcus to try this and he had an amazing experience that he’s now writing a book about and sharing at his next shareholder meeting. You learn that research backs this experience is completely safe (note: I don’t know if it is or not, so don’t quote me here), and has caused him to come up with three new Apple innovations that will change the face of technology for the next 50 years.
True or not, people react positively, and you see Apple’s stock soar to a 22% daily gain on that one day’s news.
How do you feel now?
But this happens. The news causes stocks to fluctuate up and down.
What you should have done is paused once you read the original news about Tim Cook and looked into what he was doing. Is this a safe process? Why was he doing this? Who was he doing this experience with? Will it impact the business or is this just Tim being Tim?
Those are all samples of questions you should have asked yourself before using it as a single data point in a decision on whether or not to do anything with any of your Apple stock. Keep in mind; there are many options as to what you can do here. You could sell a little bit of the stock, sell it all, or do nothing.
Yes, this example was obnoxious and fun–but things like this happen in the market every day. You have to be able to temper your emotions and use this as great data for a more informed and objective investment decision. The news itself should not be the sole driver of the decision.
Along the same lines of reacting to news comes following what others are doing. The Bitcoin phenomenon is a great example of this. Once you see others having success in doing it, you believe that you can, too. So you try to get in on the action, and it’s most likely too late (at least for the same level of success).
I’m not suggesting that doing what others are doing is a bad thing–there is some validity to this–but you need to again use it as one data point in an investment decision. Like your mom used to say “if Chris jumped off a bridge would you do it too?” (I can still hear my mom’s voice saying that.). Don’t do what others are doing just because you trust them, or trust the masses. In most situations, it’s less about the decision and more about the timing of the decision.
An Example of Following the Herd
Let’s use my crazy Apple/Tim Cook example from above as another example here. Let’s say instead you were on the opposite side of the millions of trades that happened when people found out Tim Cook was drinking Ayahuasca tea with Aubrey Marcus. You didn’t own Apple stock but were interested and saw that it was trending down and a lot of people were selling.
Most people would jump on the Apple train in a few months when the stock began soaring on the news that Tim Cook was a secret genius instead of a nut-job who goes on strange hallucinogenic field trips. But by this time, it’d be too late. The stock would have already surged 20-plus percent, and your gains would be minimal. In fact, the gain would have probably been an over-correction of the market and gone too high–so the stock would probably float down to a more normal level in a few days, causing you to have an immediate loss.
This is why you don’t follow the herd.
Instead, when you see the stock trending downward a few months prior and see the news about Tim Cook, you should be researching why. A great best practice to keep in mind is that when all else fails, buy low and sell high. Knowing this, and knowing that Apple has been a growing company for decades, you look into the news. You find that the story of what Tim is doing, true or not, is backed by research.
You’ve learned that many other CEOs have done similar experiences and it’s caused them to all have significant “a-ha” moments–whether from the Ayahuasca tea or just getting time away from their everyday lives. In most cases, this has caused their company stocks to increase. After researching more about Apple as a company (financials, leadership team, history, etc.) you determine now is the right time to buy, even though everyone else is selling.
And guess what?
You were right.
In a matter of months, you’ll be up 22% on the stock. At that point, you can either take your profits and move on, or hold the stock as a long-term play (which is what I’d recommend). So using another crazy example about Tim Cook, I’ve shown you the power of not going with the herd and instead using these types of movements as data points for your deeper research.
Another factor that can cause you to make emotional investment decisions is a personal attachment to the stock or fund you own. For whatever reason–be it gifted shares from your grandmother or shares in a company that a relative co-founded–you should detach yourself emotionally from every single investment you own. They don’t have the same feelings for you.
Having a personal attachment to an investment is much like having a personal attachment to a tangible thing in your home. Like in the show Hoarders, you can begin to hoard an investment or collection of investments, even if it starts to impact you negatively.
Just like a living room full of useless stacks of papers from the 1950s won’t do someone any good, a portfolio filled with underperforming stocks won’t help you. When you have an emotional attachment, it isn’t easy to sell those investments. This causes you to pause when there comes a legitimate time to consider selling it–and many times we end up justifying why we’re holding on to the stock (i.e., Grandma was fond of blue-chip stocks and knew General Motors would be around forever).
So remove any emotional attachment to your investments and remind yourself that you don’t need any more clutter in your portfolio. If an investment is sucking the life out of your gains, cut your losses and move on. Don’t worry, Grandma won’t be mad at you.
It’s easy to forget sometimes that because a company’s stock was beaten down in the past that it has no bearing on its future. Because I’m on an Apple kick, I’ll use them as yet another example of this. Before Steve Jobs took over Apple in 1997, the company was in a dismal position. Coming off of nearly 12 years of straight losses, many felt it was beyond saving. The stock traded at less than a dollar per share. At that point the average investor would have said that Apple was not a company to invest in.
Jobs did take over in 1997, though, and he infused the creativity and thinking that got the company started to begin with. That drive, combined with a little money from Microsoft, propelled the company upward. Fast forward a little more than two decades later, and Apple is a cultural and technological icon. The stock, as of this writing, trades at more than $190 per share.
The opposite can happen too. Don’t forget that by 2001, Enron was hailed as America’s Most Innovative Company by Fortune magazine for six consecutive years, trading at all-time highs. Then it would have seemed the company was a no-brainer to invest in. But we all remember what happened in late 2001 that changed that opinion.
Just remember that how a company or stock has performed historically carries no true indication of how it will perform in the future. It’s easy to make lazy assumptions and think that a company will continue its more recent trend, but that’s been proven wrong in so many cases.
My advice is to use it as yet another piece of data and continue to do your research. Remember, you’ll never know everything you can about investing or a specific company, and sometimes you have to roll the dice with the information you have. And you have to take risks. In reality, nobody (including its shareholders and employees) could have predicted what happened with Enron. It was a total scam. So someone who’d invested their nest egg at the end of 2000 would have probably been making, at least on paper and objectively, a good investment decision. That would turn out to be one of the worst decisions you could make, however.
Finally, if you can’t seem to control your emotions, there’s a still a way to avoid emotional investing. You can follow a system religiously and choose to not deviate from it–ever. The best non-investing example of this comes from Billy Beane and the story behind Moneyball.
If you read the book, you know that Beane was meticulous about how he chose members of his team (if you haven’t read the book, read it–it’s got some excellent lessons, and the movie doesn’t do the story justice). If someone didn’t fit an exact mold of what he was looking for, he’d get rid of them or pass on them entirely.
Many people scoffed at how he was managing his team, but he had a formula, and he stuck to it–and he didn’t let emotions get in the way of him making decisions about his team.
You can do this, too, with investing. The challenge is that you may never find a proven methodology that works consistently. Even if you do, you’ll have to be very strict in following it, and it’ll never be completely perfect.
The best “formula” I can give you is the value investing method–born from the father of value investing, Benjamin Graham. This methodology has been adopted by successful investors like Warren Buffett and focuses on companies that don’t go into debt, make good products or services, have strong overall financials, and pay a dividend to their investors (there are many more idiosyncrasies on value investing, so it’s best you check this article out and read Graham’s book).
The point is that if you have a formula that works, and you stick to it, you’ll avoid making emotionally-driven investment decisions because you’re simply following a logical pattern. If an investment fits within certain guidelines, you buy. If it doesn’t, or when it doesn’t, you sell.
Phew, that was deep. If you’ve stuck with me to this point, you hopefully have some valuable ideas on how to avoid emotional investing. To summarize, you should be identifying your long-term goals and using exterior “noise” like trends and news as data for your own objective decisions. Investment decisions shouldn’t be taken lightly, and you should make sure you know what you’re doing and what you should be looking at before buying any stock. If you’re unsure, stick to index funds, or spend the next couple of weeks digging through our investing archives.