Take the Emotion Out of Investing for Better Returns

What do we know about the basics of investing? Buy low sell high. Diversify.  Invest for the long-term. Sounds easy, but it’s not. Every day I talk to investors who understand these concepts, and yet have difficulty executing them.  For many, this knowledge of what they should do vs what they are able to do on their own is the main reason they seek out a NAPFA-Registered “fee-only” investment advisor to manage their money based on a well-designed long term plan.

The problem with investing starts with our natural inclination to want to own what has done well recently.  It makes us feel better.  It makes for a good story at the cocktail party to say we made a big bet on the latest-greatest investment.  However, recency bias doesn’t make for a good long-term investment strategy.

We also know we need to diversify, but what does that really mean?  It means owning a variety of asset classes, including those that are out of favor.  It means buying some more of these asset classes when they don’t do well.  Investments are cyclical so that today’s must have is tomorrow’s has been.  In other words, a good portfolio has assets that have a negative correlation – when one part of the portfolio goes up another tends to go down.  If everything in your portfolio is going up you’re not diversified.  How else can you buy low and sell high if nothing’s down when something else is up?  It’s no fun watching parts of your portfolio going down, but having the discipline to rebalance with your long-term goals in mind will help drive long-term results.

Successful long-term investing means not chasing results or trying to time your entry/exit into the market.  The above graphic is a good illustration of what usually happens when we try and do either.  Again, the counterpoint to emotional investing is having a long-term goal and a strategy in place to meet it.  There will be ups and downs along the way, but your goals remain clear.

Unfortunately, our brains are wired to want to chase results and make emotional decisions.  We know we are supposed to buy low and sell high but we’d rather buy into the hot investment (buying high) and then sell it when it doesn’t work out (selling low).  That’s why the average investor will consistently underperform a basic market index.

Source: 2012 DALBAR QAIB Study

Don’t think that professionally managed funds are any better.  87% of large-cap active managers underperformed their benchmark over the prior 60 months.  The same problems that individuals run into when they let their emotions take control and they chase results, occurs when professionals try it as well.  On top of paying higher fees for this ‘professional’ management you’re still likely to get sub-par results.

Certainly sounds appealing then to go to a discount broker and do it yourself.  However, this supermarket approach of picking a few stocks and funds that look appealing to us isn’t much better.  Despite the best of our intentions our cognitive biases, like wanting to follow the crowd and seeking out information that conforms to our beliefs, will come into play.  It is nearly impossible for an individual to be devoid of these emotional biases that inevitably lead to poor investment decisions. At least when you suffer poor performance with a discount broker you’ll be saving on fees.

Emotion-Free Investing Is Hard But Possible

The right approach for investors is to have an advisor manage their money who will focus on a sound long-term investment strategy without chasing short-term results.  Investors need to work with a company that is a fiduciary – that the investor’s best interest will always come first.  Investing in a brokerage house that has an incentive to put your money in their products or products from which they get a kick back is not in your best interest.  Investing with a discount broker that allows you to pick from a buffet of investment choices is not doing you any favors.

And for some peace of mind, turn off the 30-second stock market updates on your phone.  Paying too much attention to the short-term noise in the markets can cause us to make knee-jerk decisions that will be detrimental to our long-term performance.  Better to understand the long-term benefits and strategy of your portfolio and ignore the short-term ups and downs. Coming up with a sound long-term investment strategy – and then keeping your emotions in check and sticking to it – is the best thing you can do to achieve your long-term financial goals.

Bill