Leave emotions at the curb when making investment decisions

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We invest logically for the long-term but overreact to short-term emotional decisions often caused by greed and fear, destroying our investment returns in the process.
We invest logically for the long-term but overreact to short-term emotional decisions often caused by greed and fear, destroying our investment returns in the process.

The investing process often has two opposing competitors: you versus you.

The rational you versus the emotional you; and depending on who wins, the investment returns can be good or bad. Consider each of us having our own Walter Mitty split personality.

Walter Mitty is a fictional character who was introduced in 1939 in a magazine article titled “The Secret Life of Walter Mitty”. The second movie version of the story was released in 2013.

The American Heritage Dictionary defines Walter Mitty as an ordinary person who indulges in fantastic daydreams of personal triumphs. I think there is a little of this character in most of us.

We think of ourselves as logical adults capable of making good decisions. Unfortunately, when it comes to investing we have a split personality. Logical versus emotional.

We invest logically for the long-term but overreact to short-term emotional decisions often caused by greed and fear, destroying our investment returns in the process.

This column has reviewed evidence showing how many investors have significantly inferior returns compared to the stock market. In theory we attempt to buy low and sell high. More often we do the opposite.

If you invest for 20 years and achieve an annual return of 7 per cent, a $10,000 investment will grow to more than $38,000. If your return is only 4 per cent the capital will only appreciate to $22,000.

There was an interesting article in the September 12, 2014 edition of the Wall Street Journal titled “Three Mistakes Investors Keep Making Again and Again”.

The first mistake is incorrectly predicting your emotions. Our thoughts on emotions are to understand that they affect investment decisions. We must be realistic and manage our expectations.

Anticipate that emotions will ebb and flow. Try your best to avoid strategies that require you to make a lot of guesses on buying and selling and generally changing direction based on human emotions.

While you are trying to stabilize your emotions, understand just how unstable investment returns are in the short-term. Market volatility is normal. That is how markets work.

If you are not able to cope with volatility, then try to build that reality into your investing approach. As an extreme, an investor might decide to avoid investing in stocks or mutual funds that own stocks.

Be cautious avoiding stocks completely because they are the best source of long-term gains compared to safer and lower paying fixed income investments such as bonds. However, investing in stocks without discipline will likely prove to be one of your worst investment decisions.

From 1900 to 2013 the U.S. stock market posted an average annual return of 6.5 per cent after accounting for inflation and dividends. This is according to the 2013 Nobel Prize winner Professor Robert Shiller from Yale.

A 6.5 per cent return looks very stable but look underneath the surface and you will see that is not the case. The average difference between the stock market high and low each year was 23 per cent. Returns can look stable over time but that does not hide the extreme volatility occurring during most years.

Our advice is when it makes sense then by all means invest in the stock market. Never attempt to predict the short-term and base investing decisions on those predictions.

A study in 2005 by investment bank Dresdner Kleinwort reported analysts who are paid to predict the future, waited for stocks to move or interest rates to change and then predicted what had already happened.

There is no crystal ball when guessing the future. Not for professional analysts and most certainly not for individual investors.

Wise investing is mostly about common sense. Save some of what you earn and invest wisely in low cost widely diversified securities.

Avoid the temptation to make investing more complicated than it is by guessing market swings and acting emotionally.