Monday, October 19, 1987—aka Black Monday—was a fearful day for investors across the globe. The damage exceeded 20% in stock market declines by the time the exchanges closed. In the wake of such steep declines, investors too often are driven to act by their emotions. In this case, fear. Fear that the decline will continue. Fear that their hard earned savings will be sucked dry by the markets. A more recent example of this fear was invoked by the financial crisis. In both cases the markets recovered in short order. But, the market never recovers for those who sell out of it. Clearly, fear selling is a bad idea.
Fear is not the only emotion that muddles our investment decisions. Greed is just as dangerous.
The 1990s seemed too good to be true. Investors could not lose money in technology stocks. Valuations seemed to have changed and the exponential rising prices were within the new norm. People got greedy. Some went so far as to use their home equity to purchase stocks. And then, just like that, the party was over. The end of the decade saw technology stocks come crashing down. Those who got greedy and concentrated all of their holdings in technology stocks paid the price.
Anytime the sky is falling or the markets seem too good to be true, remember the mantra—be greedy when others are fearful and fearful when others are greedy.
While fear and greed top the list of emotions that can wreak havoc on your investments, there are others: angst and excessive pride, for instance.
The issue with angst is if you wait for events to happen (government shutdown, fiscal cliff, quantitative easing, etc.) or for the markets to “normalize,” you often miss the boat.
Excessive pride can sometimes drive people to buy individual stocks. It’s the classic cocktail party conversation where someone tells you they bought Microsoft stock in the 1990s or Apple stock at the turn of the century. They do not tell you about the other 10 stocks they bought that went south. By focusing on the one home run, people subconsciously convince themselves that investing in individual stocks is a wise venture. It’s not. In fact, it’s speculation, not investing. Do not let pride get in the way of making smart investment decisions.
Clearly we cannot let our emotions guide our investment decisions. Emotional investing is not successful investing.
Follow these steps to help avoid the pitfalls:
1) Build a plan. Write it down and stick to it. If the markets turn over, do not deviate from your plan. If anything, rebalance your accounts back to their initial targets.
2) Turn off the news and tune out the financial pundits. In the age of information, the evening news is not going to give you a leg up on investing. That is, everyone knows everything and it is all factored into the price of securities.
3) Do not assume things are correlated when they are not. GDP is not nearly as highly correlated to stock market returns as people think. Nor, for that matter, are political events.
4) Diversify your portfolio. Put another way, do not put all of your eggs in one basket. Remember what happened to technology stocks in the 1990s.
5) Focus on what you can control. You can control how much you save and whether or not you succumb to your emotions. You cannot control the markets and politicians.
Here’s the exciting part: if you can keep your emotions at bay, invest wisely and let the markets work, you can reduce your stress and increase the likelihood of a successful retirement period.