Markets

How Emotions Can Hurt Your Investment Portfolio

You need a logical investment strategy to help manage how you're bound to react to the ups and downs of the market.

"I love it!"

"I hate it!"

Both are emotional comments about almost anything, and they certainly carry over when it comes to investing. After all, we're only human.

Why might this be a good time to have a discussion about this topic? The first two months of 2016 have been interesting, to say the least when it comes to investing. And 2015 wasn't so great. So, how should you deal with this current uncertainty? Before we arrive at an answer to this, it would be helpful to look at how we humans emotionally react to the up and down movements of the investment markets. As a believer that a picture is worth a thousand words, I offer the picture below for us to examine:

Thinkstock

As the markets move up, even though it's never in a straight line, we go from optimism to euphoria, where the maximum potential risk level is reached. We now truly believe we are geniuses! What could possibly go wrong when we're so smart?

As the markets move down, as they all do at some point, our emotional state changes and we try to justify why we couldn't possibly be wrong. And as the slide continues, our emotions get stronger and stronger with fear kicking in more and more. And more often than not, we're more concerned about being wrong than the value we might be losing. How could we suddenly have gone from being so smart to being so dumb?

Invariably at the bottom of the market, our emotions have become so overwhelming that we convince ourselves that we really don't know anything, and now it's time to get out. Or we might think this whole investment process is rigged against us since it couldn't be possibly our faults. This happens at precisely the most opportune time to be in the market.

But before we can muster the emotional fortitude to jump back in, our depression needs to wane and hope, relief, and optimism need to take over again so we can decide to invest now.

Understanding how this cycle repeats itself could make you a better investor, but there are no guarantees of that. You also need to learn to not let emotions have much of any part of the investing process. How can you accomplish this?

You need a plan. A logical plan based on fact, not emotion. You need to think like Mr. Spock in Star Trek.

I'm not an advocate of simply buying the whole market and holding on forever. Yes, over a long time the markets inevitably go up, but your timeline may not be that long. I have never bought any investment for a client that we expected to hold forever. Nothing works forever.

There have been multitudes of successful investors over the years that have lived by the mandate that you have to be willing to buy when everyone else is selling and sell when everyone else is buying. If this feels emotionally difficult to do, that is exactly why we need a logical plan of what to buy, when to buy it, when to sell it, how much of it to buy and what are the key factors to go into determining all of these things. (This is a subject intended for a future article, so stay tuned.)

Hopefully, this discussion helps to explain why we, as humans, react the way we do, and how that natural reaction can be a negative when it comes to investing. It's negative in the sense that we may be buying high and selling low because our emotions tell us to do it that way, but also negative in the overall emotional turmoil it can cause.

Do yourself a favor. Understand what's going on in your heart and your head and have a plan to let logic rule the day, especially when it comes to investing.

Charles C. Scott, Accredited Investment Fiduciary®, has more than 30 years of experience in the financial services industry. "Our mission is to help our clients discover, design and live the life that they want to live by matching their finances with their visions, values and goals."

About the Author

Charles C. Scott, AIF®

President, Pelleton Capital Management, Ltd.

Charles C. Scott, Accredited Investment Fiduciary®, has more than 30 years of experience in the financial services industry. He developed and managed an institutional sales department for Washington Mutual, and then served as the Northwest Regional Manager for MFS, America's oldest mutual fund company. Since 1993, he has been an independent adviser, focusing on providing his clients with objective, unbiased planning and investment advice. He has written for the Wall Street Journal, CFO Magazine and other publications.

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