While many of us understand that our emotions can compromise our long-term financial goals, it isn’t always easy to ignore media hype. But letting emotions guide our investment decisions can have a real impact on our portfolios.
Sometimes what seems like a reasonable investment strategy is actually emotions in disguise. We believe these emotional strategies can be particularly harmful, because at first glance they may seem like good, even rational, ideas.
Emotional strategy: Waiting for the “right time” to invest. Timing the market is almost impossible to do successfully, even for most professional money managers. Many investors after the Great Recession sat on the sidelines as U.S. markets went up and up, almost tripling in less than a decade. In 2016 and 2017, some financial experts predicted an imminent stock market decline. If you had invested according to their predictions and taken money out of your portfolio (or stopped investing), you would have missed out on a 12% total return in 2016 and a 22% total return in 2017 in the S&P 500. Eventually, a bear market will happen, but it is almost certainly riskier trying to predict it and avoid it than to ride it out. Smarter strategy: Ignore the pundits (and your own emotional impulses) and invest for the long term.
Emotional strategy: Buying the stocks of popular, innovative companies that are generating buzz amongst your friends. While it is fun to feel like you are part of a cool club and are investing in the future, innovative companies are not always the most successful investments. Take Google and Domino’s, which both went public in 2004. Google, which continues to make incredible inventions and technological advances, returned 1985% through the end of 2017. Meanwhile, Domino’s, which makes pizza and breadsticks, returned 2720%.1 Whenever you invest in a limited number of companies, you become susceptible to what is called idiosyncratic risk, or risk that applies only to one type of asset. For example, a company’s miracle drug could turn out to be a bust, or the CEO of another company might make embarrassing public pronouncements … and suddenly you are faced with major losses. Smarter strategy: Own a broadly diversified portfolio, so that troubles with one company, or sector, or country, have less impact on your overall portfolio.
Emotional strategy: Investing in products or managers that purport to have some special “edge.” This is almost the entire premise of the hedge fund industry, which claims that its proprietary algorithms and cutting-edge research make it well-positioned to deliver outstanding performance. Over the past decade or so, the reality has been much less impressive, with hedge funds, as a whole, significantly underperforming the S&P 500. Because hedge funds are not subject to the same investor protection regulations as other types of investments, they may provide less transparency about their strategies. Smarter strategy: Invest in products, such as mutual funds, that are highly regulated … and avoid any product or manager claiming a “secret sauce” or applying untested methodologies (or tested methodologies that don’t generally work that well).
Your financial advisor can help steer you away from fads and emotional decisions and toward rational strategies that are based on decades of academic research and insight. As the money manager Jim Rogers noted, “People are too quick to accept conventional wisdom, because it sounds basically true and it tends to be reinforced by both their peers and opinion leaders, many of whom have never looked at whether the facts support the received wisdom. It’s a basic fact of life that many things ‘everybody knows’ turn out to be wrong.”
1 Source: Yahoo Finance as of 12/31/2017