Investors have a knack for piling into investments at the top and selling at the bottom. Many investors get caught up in media hype or fear and buy or sell investments at the peaks and valleys of the cycle. Active monitoring of a portfolio can be important for navigating the changing tides of the investment market but for individual investors it can be critical to manage the behavioral impulses for buying and selling that can come with following the market. Here we talk about some of the motivations behind emotional investing and some alternatives to both euphoric and depressive investment traps that can potentially be more profitable. Read on for some tips on how to navigate what can be a volatile investing market while also keeping an even keel and keeping your portfolio diversifications optimized for the best overall returns through all types of market environments.
Tutorial: Understanding Behavioral Finance
Investor behavior has been well documented. There are numerous theories that attempt to explain the regret and overreaction that buyers and sellers experience when it comes to money and the potential gains and losses on that money. Investors' psyche can overpower rational thinking during times of stress, whether that stress is a result of euphoria or fear. Taking a rational and realistic approach to investing during what seems like a tight timeframe for capitalizing on euphoria or fearful market developments can be essential.
Typically, the non-professional investor is putting his hard-earned cash in investments for the sake of receiving a return. Investors never invest to lose money but at times they see their investments falling due to market developments tied to risks. Investors get investment information from many sources, including subscription platforms, mainstream media, financial news, friends, family and co-workers. Oftentimes investors can get enticed by the market based on information from any of these sources. As a result, it is important to keep risk and risk tolerance in mind when pondering new or existing investments.
Risk can be a guidepost for investing and investor behavior. Investors who enter into investments with a base level understanding of the risks involved can mitigate a great deal of emotional investing. Challenges in emotional investing can often come when investors see unidentified or higher stake risks than they originally ascertained.
Bull markets are periods when the market tends to go up indiscriminately. During such times of market exuberance, investors can often see market opportunities or learn about investments from investing sources - such as stories, friends or family – that may compel them to test new waters or try to obtain gains from profitable investments that may be emerging due to bullish market conditions. Likewise, when investors read stories about a bad economy or hear reports about a volatile or negative market period, fear for their investments can fuel selling.
Inversely, bearish markets are always lurking around the corner and come with many of their own caveats that can be important for investors to follow and understand. Oftentimes bear markets evolve from an environment of rising risk-free rates that can spur risk off trading and a transition of assets from high risk equities to low risk savings products. Bear markets can be difficult to navigate as investors see their equity holdings falling while safe havens become more enticing with their rising returns. During these times it can be hard to choose between buying at market lows or buying into more cash products generating safe returns of 3% to 5%.
Emotional investing is often all about timing. The lag between when an event occurs, when it is reported and when the opportunity is exhausted or lost can often be short since comprehensively markets are expected to generally be efficient. The efficiency of the market can be an important consideration for emotional investors. Using rational realistic thinking to understand when an investment opportunity may be in a development cycle can be important to gauging bets and resisting when opportunities may be lost.
Following the media can be a good way to detect when bull or bear markets are evolving but its important for investors to also follow trends as well. The influence of the media can help support investing opportunities, but rational investment theory must also be used. The daily stock market reports feed off the activity occurring through the day and at times can create a buzz for investors that can be outdated, short lived, or even non-sensical or based on rumors. Overall individual investors are ultimately accountable for their own trade decisions and therefore must be cautions when seeking to time market opportunities.
Time Tested Theory
There are theories that many market participants buy at the top and sell at the bottom and these theories have proven to be true based on historical money flow analysis. Money flow analysis looks at the net flow of funds for mutual funds. Money flow analysis will often show that when markets are hitting peaks and valleys, buying and selling are at their highest. Market anomalies like the financial crisis can be good time periods for observation. Leading up to the peak of the Financial Crisis in 2009 money continued to flow into funds until the market hit bottom, and then investors started to pull money out of the market and money flows turned negative. The net outflows peaked at market bottoms and as is typical for all market bottoms, selling created demand for overly discounted investments helping the market to ascend upward. Understanding Investor Behavior.)
Strategies to Take the Emotion Out of Investing
Morningstar’s annual Mind the Gap study helps to define emotional investing and show how money flows in and out funds affect investors’ returns in relation to fund returns as a whole. As of 2018, active investment in alternatives, balanced funds and sector stock showed to be more profitable than simply staying the course. In Morningstar’s other study categories: international, municipal, taxable bond, U.S. stock, and U.S. stock and sector – active investors underperformed in relation to the actual funds' returns over ten years.
Comprehensively, there are strategies, however, that can alleviate the guess-work and reduce the effect of poorly timing fund flows. Two of the most popular include dollar cost averaging and diversification. The most effective tends to be the dollar-cost averaging of investment dollars. Dollar-cost averaging is a strategy where equal amounts of dollars are invested at a regular, predetermined interval. This strategy is good during all market conditions. During a downward trend, investors are purchasing shares at cheaper and cheaper prices. During an upward trend, the shares previously held in the portfolio are producing capital gains and fewer shares are being added at the higher price. The key to this strategy is to stay the course- set the strategy and don't tamper with it unless a major change warrants revisiting and rebalancing the established course. (There is more than one way to work this strategy. Find out more in Choosing Between Dollar-Cost and Value Averaging.) This type of strategy can work best in 401(k) plans with matching benefits.
It can however be challenging and tedious in brokerage account investments but certainly worthwhile.
Diversification techniques often diminish the emotional response and impulse to market volatility and emotional investing giving investors confidence in their allocations across the market. There have been only a handful of times in history when all markets have moved in unison and diversification provided little protection. In most normal market cycles, using a diversification strategy provides downward protection.
Diversifying a portfolio can take many forms - investing in different industries, different geographies, different types of investments and even hedging with alternative investments like real estate and private equity. There are distinctive market conditions that favor each of these subsectors of the market, so a portfolio made up of all these various types of investments should provide protection in a range of market conditions.
Times of rising risk-free rates can be an optimal time to increase allocations to risk free investments or identify top performing investments in the low risk category. For many investors portfolio optimization overall involves following the risk-free rates of investments and adjusting as market environments change.
The Bottom Line
Investing without emotion is easier said than done but there are some important considerations that can keep an individual investor for chasing futile gains or overselling in panic. Understanding your own risk tolerance and the risks of the investments you invest in can be an important basis for investing decisions. If unidentified risks present themselves it can lead to reevaluation and a change in investment perspective on a security. Active understanding of the markets and what is driving bullish and bearish trends can also be very important. Regardless of the sources used, investing prior to the peak of a buying or selling opportunity is always the best time and investors must be cautious in chasing exhausted rallies or selloffs. Overall while there are times when active and emotional investing can be profitable, data shows that in most categories following a well-defined investing strategy and staying the course through market volatility often results in the best performance returns.