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Last Updated on: 27th June 2023, 08:51 pm
Emotions have their place in decision-making. They can make us more empathetic, and more conscious of the broader societal impacts of our choices, and can even generate more rational outcomes.
Yet, just as often, emotional investing can burn us—causing deep financial losses that can set our financial goals back by years.
All investors are guilty of making poor, overly-emotional financial decisions, including myself. While they are nothing to be ashamed of, emotional investments should be avoided more often than not. In fact, the scientific link between emotions and non-rational financial decision-making is well-established in the literature.
Instead, financial investing should, in most cases, be rational and utilitarian. They should impartially evaluate risks, and weigh them against potential forecasted returns. And while we can’t control which direction the stock market will swing, we can control how much risk and reward we’re willing to tolerate.
Want to learn more about avoiding the financial mistakes that come with emotional investing? Read on to discover simple guidelines for approaching your financial life with greater clarity, impartiality, and cost-saving objectivity.
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Why Is It Important to Make Financial Decisions Without Emotions?
Again, financial decision-making can benefit from instinctive emotional considerations; but these considerations should never take priority over rational thinking.
A common pitfall of irrational emotional investing is to buy high and sell low.
For instance, the S&P 500 stock market index dropped 7.6% during the intraday trading day on March 9, 2020, just as the coronavirus pandemic was unfolding. As it happened, many traders sold their positions to cut their losses. The uncertainty in the market brought forward a host of negative emotions or dispositions in traders, such as fear, panic, and greed.
However, traders who waited out the bear market were rewarded with handsome returns when economic conditions stabilized and optimism recovered.
By the end of the year, less than nine months later, the S&P 500 closed at all-time highs. As of Q3 2023, the index is up +26.2% over its pre-crash value in February 2020.
Using Rational Methods to Invest Smarter
Inductive reasoning refers to a rational decision-making method that insists on drawing valid conclusions from the specific to the general.
While past market results are not indicative of future performance, inductive reasoning tells us to wait out dips in the market rather than reflexively liquidate our positions.
Since the S&P 500 was first listed in 1923 (or the Dow Jones, or any broad public stock index), its per-share value has only trended upward over time, even after adjusting for inflation. This, despite deep systemic setbacks suffered during the Great Depression, the stagflation of the 1970s, Black Monday of 1987, the dot-com bubble, and the Great Recession.
S&P 500 Index from 1923 until early 2020s (Image Source: Medium.com)
During a recession, can use our inductive reasoning skills to assess that the underlying economic conditions have not changed significantly from those of other historic recessions. If the fundamental conditions remain the same, there is no reason to assume that economic growth won’t resume in the near future, as it did in every other instance.
Those who adhered to this reasoning principle were rewarded following the 2020 stock market crash—as well as every other stock market crash in history.
By resisting the emotional temptations of fear and greed, we can infer (ceteris peribus) that exercising rational patience and restraint will serve us better in the long run. As the adage goes, “It’s not about timing the market, but about time in the market.”
6 Tips for Avoiding Emotional Investment Strategies
You can’t implement a rational investment strategy without first laying the groundwork. Certain first principles should be adopted in order to guide your decision-making on calculated grounds.
To minimize the risk of costly and irrational emotional investments, I suggest the following:
1. Establish your investment goals
Before investing, it’s important to have a clear understanding of your investment goals. Write them down and refer to them frequently. This will help you stay focused on your specified goals and avoid making knee-jerk investment decisions that contradict your long-term interests.
2. Diversify your portfolio
Diversifying your portfolio can help reduce risks inherent to financial markets and can reduce the likelihood of becoming too emotionally attached to any one investment. Consider investing in a mix of assets such as stocks, bonds, commodities, and non-correlated hard assets such as physical precious metals.
3. Stick to a long-term plan
Avoid making impulsive decisions based on short-term market fluctuations. Develop a long-term investment plan that accounts for your goals, risk tolerance, and investment horizon. A longer investment horizon (i.e., >10 years) generally suggests that you can absorb more risk and be more resistant to day-to-day portfolio adjustments.
4. Practice mindful investing
To avoid costly reactionary decision-making, it may help to practice daily mindfulness. This skill has a host of benefits not exclusive to finance and investing.
By remaining mindful, you can be aware of the negative emotions that may arise during your investing journey, and observe them without reaction when they do not serve your long-term goals.
5. Avoid timing the market
While some day traders can profit from intra-day price movements, these cases are far and few between. More often than not, they result in disastrous losses. Instead, refer to your long-term goals and use inductive reasoning to determine whether a traditional buy-and-hold strategy will get you closer to your goals faster.
6. Seek professional advice
Before making any knee-jerk changes to your portfolio, consult with a qualified financial advisor. They can assess your financial situation through an impartial lens, and help guide your decision-making to avoid costly mistakes that run counter to your long-term goals.
Avoid Fear and Greed: Practice Mindful and Rational Investing
Most financial mistakes are motivated by fear or greed. Learning to recognize these negative emotional states can save you a lot of money in the long run by helping you avoid impulsive and reactionary decision-making.
Historically, markets have trended upward. This trajectory has been maintained throughout periods of extreme volatility and disruption, such as the Great Depression.
On a long enough time scale, we can use inductive reasoning to infer that markets will continue to trend in this direction. Bearing this in mind can help save you from panic selling when downturns inevitably occur, or from overcommitting to an emotional investment.
To fortify your portfolio against emotional investing, you may want to consider diversifying your holdings across a variety of non-correlated asset classes. That way, you won’t be overexposed to any one type of risk inherent in the market. You can get started by opening a self-directed IRA account with one of America’s top-ranked SDIRA providers.