How To Protect Yourself Against Emotional Market Cycles

April 19, 2017
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Investors often fall into the trap of deciding to BUY when they are confident and SELL when they are frightened. This unfortunately can translate to an unsuccessful pattern of buying high and selling low – the exact opposite of what they are trying to achieve.

Why is this?

Quite simply – average investors naturally feel confident when the financial markets are up and can experience deep concern and anxiety when markets are down. In an effort to grow assets or protect capital, investors can react emotionally to these market cycles and thereby find themselves buying and selling at the worst times.

This is certainly an obvious behavior to avoid. Yet, this happens to perfectly normal, intelligent people. It’s human and we’ve all felt these emotions.

To illustrate, refer to Diagram 1 below. Notice how the investor’s emotion changes as they move through market cycles. Have you felt these emotions before? Of course, you have… From caution to confidence, greed, then denial and ultimately panic, investors may find themselves reacting to the market with BUY and SELL urges which can actually be opposite of what might be advisable. Not a fun day!

So, what should investors be preparing to do during a market decline?

The flip answer is obviously BUY. However, this is easier said than done, especially if there’s cash or income constrain and perhaps a lack of contingency planning. The point is – this emotional cycle can be dangerous and so it’s often better to keep intense emotions out of one’s decision making.

Diagram 1.

 

Is this a new problem?

No. Behavioral finance research has documented this issue well.

However, unlike any time before, investors are barraged with all kinds of information, including quick-opinion media and talking heads who do not necessarily have a context of OR an interest in the individual investor’s long-term goals.

Electronic devices scream for attention and investors are often pushed vast amounts of information they weren’t necessarily seeking to begin with. This can exacerbate the problem and make it difficult to separate emotion from any kind of pre-determined decision framework or longer-term financial goals. Instead, there should be a deliberate, well thought out strategy, grounded in a longer-term perspective to guide one’s investing decisions.

What kind of impact can emotion-based decision making have on your financial plan?

Letting emotion drive decision making can create devastating effects.

Look at Diagram 2 below where an investor exited during a recent deep market decline and then got back in 2+ years later. What was the result? He missed much of the market turnaround. Notice the impact on long-term performance between the two scenarios – “Staying In” vs. “Getting Out.”

Diagram 2.

 

So, how can you manage the emotional element of investing?

It is easier said than done. And, “just staying in the market” is not a complete or accurate answer. However, here are some general thoughts:

  • First off, step back and take a comprehensive view of your financial life.
  • Do the best you can to define your family’s time horizon as well as your personal level of risk tolerance. This can help clarify how the money should be positioned.
  • Begin with the end in mind. What are your financial goals? To accomplish this, consider the following questions:
    • “What’s important to me?”
    • “What’s this money for?”
    • “What do I want this money to accomplish?”
  • Consider incorporating traditional concepts like dollar cost averaging and portfolio diversification into your plan.
  • Understand that quick-opinion media is just that – it’s a quick, general opinion and is not likely tailored to your individual situation. Lacking this understanding and reacting inappropriately to market cycles can hurt long-term performance and make for a painful journey.
  • Don’t put unnecessary pressure or expectations on yourself. Financial topics may or may not be your strength. If you’re uncertain about your financial plan, meet with a financial professional who can help.

Removing all emotion from investing is near impossible. However, being deliberate in your financial planning and getting educated about how to better mitigate the emotional aspects of financial decision-making is a healthy process, not just for long-term performance, but also for overall financial peace of mind.