Emotional investing is when investors make decisions based on a feeling instead of how the market is actually performing or likely to perform long-term. Two major emotions that can drive investments are fear and greed. Up or down, emotional investing may happen at any time, regardless of market performance. Often, times of recession cause investors to pull out of the market too soon instead of riding the wave, losing out on their investments.
As an investor, it’s important to manage the impulses associated with emotional buying and selling when the market fluctuates. With an understanding of what emotional investments are and when the impulse might strike, you’ll be better equipped to avoid them. Learn more about how to prevent yourself from making emotional investments.
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The Emotional Cycle of Investing
Fear is often the motivator when a market is in a pullback. In these instances, an investor will often sell their stock too soon because they fear they won’t get a favorable return on their investment. In reality, investors who act out of fear might lose out on bigger benefits down the line.
Fear can cause an investor to miss out on the appreciation of stock values and the high dividends that come as a result. The fearful investor is also at risk of buying low-risk stocks that are deemed “safe” but come with low returns.
Conversely, greed also influences investors at times. Acting on greed and impatience can wreak havoc on a portfolio. Many times, an investor won’t see results as quickly as they might want to, causing them to get greedy and invest in more stocks that might have larger risks.
How to Avoid Emotional Investing
There’s no perfect approach to investing, but if you can keep your emotions in check when making financial decisions, you’ll have a better chance of being successful. Follow these tips to avoid emotional investing.
Set Investment Goals
Investing requires you to think about what your long-term goals are — you can’t just pick the stock options you want to invest in at random. While investing allows you to buy and sell stocks with a short-term mindset, you should still have long-term goals in place.
To set these goals, consider why you’re investing in the first place. How much time do you have to invest? Someone who is planning for retirement will likely have more time to grow their investment portfolio, and they will probably make safer investments that they’re sure will grow, allowing them to steadily reap rewards over time and have enough money for retirement.
Conversely, someone who is investing with their discretionary income will most likely have a vastly different investment strategy. They might be willing to invest in riskier stock options because there isn’t as much riding on their investment as someone who is investing for retirement.
Next, consider what you hope to get out of investing. Perhaps you want to have enough money to retire early, or maybe you want to purchase a second home. Regardless of your reasoning, there should always be a purpose as to why you’re investing. Setting these long-term financial goals will help you make smart investment decisions.
No matter what your investment goals are, it’s important to have them so that all of your investments are rooted in strategy, not fear or greed.
Create a Diverse Portfolio
Diversifying your portfolio is an important part of any investment strategy. When it comes to emotional investing, a diverse portfolio mandate can help prevent you from making decisions out of fear or greed and allow you to choose a variety of investments and ultimately earn a higher return.
A diverse portfolio will also reduce the desire to mess around with your asset allocation. By following an investment strategy that includes individual stocks, bonds, and different types of mutual funds, commodities, exchange-traded funds (ETFs), and real estate investment trusts (REITs), you can feel confident in your approach.
Buy Low, Sell High
When all else fails, investors defer to a simple rule — buy low and sell high. That said, with any investment strategy it’s important to pay attention to what the market is doing, as well as why it’s changing. For example, if a stock you’re invested in suddenly declines, don’t panic. Instead, you should investigate why. With an understanding of why the stock is behaving the way it is in the current market, you’ll be able to make a smart decision that isn’t rooted in the emotion of panic.
Create Your Own Set of Rules
Just because an investment strategy works for someone else doesn’t mean it’s going to work for you. Create your own set of rules so that your investment strategy remains true to your personal budget, needs, and lifestyle.
Otherwise known as your risk tolerance, your rules will dictate how much volatility you’re willing to withstand in your investment strategy. For example, establish the lowest price at which you’re willing to sell a particular stock. If the value of that stock drops to your price point, it could be time to part with it, depending on the other assets in your portfolio and the market forecast.
Read the News for Information
The daily news is an important source of information for investors. As mentioned previously, it’s essential to stay updated with the latest goings-on in the market. The news can evoke an emotional reaction out of investors, both good and bad. It’s important to remember that while the news is a useful tool for gathering information on stocks and the market performance, it shouldn’t be the sole factor on which you base investment decisions.
Whether you’re new to investing or a seasoned veteran, understanding the motivations behind emotional investing will allow you to avoid the mistakes that may come out of it. Regardless of whether you choose the low-risk, safe investments or take chances on a tech trend or other volatile stock, you can prevent poor investment decision making and maintain a diverse portfolio by taking a rational and realistic approach to investing.
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