If you're letting fear — or worse, greed — drive your investment choices, you could be setting yourself up for financial trouble. Here’s what you need to know about emotional investing and why it’s best to avoid getting trapped on this financial merry-go-round.
What Is Emotional Investing?
When the market is up, you buy more out of greed. When the market is low, you sell out of fear. This cycle of market emotions influencing your investment decisions is known as emotional investing.
Emotional investing can be explained by the “herd instinct.” Put simply, it’s the FOMO effect, or the fear of missing out. For example, you hear a business news anchor mention that stock in a new technology company is on the rise. Then you feel an urgency to buy that stock because you think so many others will, too. It’s natural not to want to miss out on the next big stock that could yield great returns. However, basing your trading decisions on fear of missing out can be detrimental if it doesn’t align with your long-term investment goals.
The other part of the investment fear factor influencing your trading strategies is losing money. Your stock may be down, but instead of staying the course, you sell, afraid you’ll lose more of your investment.
Greed is also a strong feeling that could lead you to make an emotional investment mistake. Driven by a desire to make fast cash, you invest blindly hoping for a quick return on your investment. You figure you can cash out and get rich quick. Remember, news anchors are not your financial advisor. They don’t know about your investment goals and priorities.
Are You an Emotional Investor?
Test your resolve by thinking through how you would react in the following situations.
A trusted friend tells you they have a great opportunity to double your money — but you have to act right away.An emotional investor might get swept up in the excitement of the moment and write a check immediately. Or they might feel a sense of obligation to their friend and let their guilt persuade them to invest. Rather than give an answer straightaway, tell your friend that you need time to think it over and do more research. And keep in mind that if something seems too good to be true, it probably is.
During a period of market volatility and rising interest rates, you start to worry about the future and consider selling. This type of emotional trading is what causes so many people to buy at the top and sell at the bottom. The key to getting back into the black? Stay the course. In dollar-cost averaging, a popular investment strategy where equal amounts of dollars are invested at a regular, predetermined interval, investors are encouraged to set the strategy and leave it alone, barring any major life changes.
Your neighbor made millions during the tech boom, and you’re determined to do the same. For investors who get caught up in comparison, it can be easy to spend years searching for — and investing in — the next big thing. Rather than trying to achieve a massive windfall via a particular company or industry, opt for healthy portfolio diversification. In normal market cycles, using a diversification strategy provides an element of protection because losses in some investments are offset by gains in others.
How to Manage Emotional Investing
So how do you avoid making emotional investing mistakes? These tips can help you break the cycle of investor emotions by taking a broader view of your portfolio, putting you on the path toward a more balanced financial future.
1. Prioritize Your Goals
Instead of investing emotionally, keep your short- and long-term financial goals in mind when making investment decisions.
2. Invest Routinely
Consider a routine investment strategy known asdollar cost averaging. This is simply committing to investing a fixed amount of money at fixed times. An easy application of this strategy is a biweekly contribution to your 401(k) plan. You’re investing a percentage of your income into a mutual fund, for instance, whether the price goes up or down. There’s no emotional investing at play.
3. Diversify Your Portfolio
Portfolio diversification is another way to overcome emotional investing. Diversifying your investment portfolio is a standard practice to help reduce the impact of market volatility. Plus, it allows you to stay focused on your long-term investment goals.
Meet With a Professional
Your Farm Bureau financial advisor can help you develop a sound financial plan based on your strategic goals.
