Why emotion and investing don't mix

Avoid snap investment decisions

Economic conditions are always changing and the markets can behave like a rollercoaster. With so much of your future and hard work tied up in your investments, it can make for some moments of high anxiety. But reacting emotionally can cost you financially and affect how you'll invest in the future. The key is to stay calm when markets get bumpy and avoid the mistakes others will make.

Throughout history markets have followed a natural cycle. Optimism will drive asset prices a step too far leading to an inevitable decline. We can see this in the historical performance of the S&P/TSX Composite Index (and its predecessors) going back decades. Based on annual patterns, we can expect a negative market on average about once every four years followed by a return to growth.

When markets are running strong, people feel confident about taking risks in their quest for a higher return. But when prices sag, that enthusiasm quickly disappears. Instead of accepting occasional declines as a normal part of investing, people often get scared. If things get bad enough they sell out – likely at a low price.

Renowned financial research firm, Dalbar, has tracked the long-term behaviour of mutual fund buyers in the U.S. and found that psychology – not just economics – is at work when it comes to investment performance. The research shows the average investor underperforms market indexes by a wide margin; a difference so large it can't be explained by fees alone.

Over the past 20 years, the average equity fund investor earned less than 4% annually. At the same time the market (S&P 500) produced an average 6% gain. And it isn't just stock investors who fell short. Fixed income investors barely squeaked out a 1% annual return compared to a 7% average rise in the index.

Market losses can make you more cautious in how you approach investing, and this can steer you toward investments that are too conservative. For most people, taking on a degree of risk is critical to generating enough growth to achieve goals and protect wealth from inflation, especially when it is needed as income in retirement.

But how can you take emotion out of investing and stay on the path to achieving the results you want? Here are a few tips to help you keep calm and carry on.

Tune out the noise

Even if you're not the worrying type, there are times when it's almost impossible to ignore the mood of the market. Between the 24-hour business news cycle, smartphone notifications, and social media chatter, never before has the average investor had access to so much information so easily.

While you might think experiencing the world in real time can make you a better investor, if you're not careful the opposite will happen. Here's why.

Typically, the more volatile things get the more you'll watch the markets, mistakenly thinking you'll be able to spot major trouble just before it happens. The more you watch, the more anxious you become. While all that watching won't change anything, it will increase the odds you'll overreact to the headlines and make a rash decision with your investments.

Try a more balanced approach. Be aware of what's going on, but resist the temptation to over-monitor your portfolio. If you ignore the headlines and daily twists and turns of the market you'll be better able to keep emotion in check and stay focused on what matters most – your goals.

Evaluate and rebalance

If you're a long-term investor "buy-and-hold" can easily turn into "set-and-forget". Market volatility offers a good opportunity to stand back, take a look at your portfolio, and decide if any changes need to be made.

If you worked with your advisor to establish an asset mix of stocks, bonds, and cash suited to your risk tolerance and objectives, now's the time to compare your portfolio against that target.

Stocks have made a strong recovery since the economic crisis of 2008 and 2009. Has that left you overweighted in equities and underweighted in bonds and cash? If so, consider locking in profits by shifting some of your investments out of equities and into other asset classes to restore your ideal mix. This process will help you to "sell high" and "buy low" as well as keeping your portfolio's risk in check.

While no one likes to lose money, there may be times when selling at a loss makes sense. An investment might have little chance of regaining its value or perhaps it no longer fits your plans. Holding on means you tie up valuable cash that can be put to work elsewhere. You also create tax benefits when you sell.

Use losses to first offset any capital gains you incur from rebalancing your portfolio. This will reduce taxes you might otherwise have to pay. Afterward, if you still have losses you haven't claimed, you can apply these against future gains or carry them back up to three years.

Learn from history

It's challenging to keep your nerve during sudden market drops that hurt your portfolio. But as history teaches us, dark days eventually end and markets resume their advance.

Unfortunately you may not remember this lesson in the times when you need to most. People can overreact and convince themselves that each downturn they're experiencing is "different" and somehow worse than anything they've gone through in the past.

But rebounding from a crisis is something financial markets do well.

Think about what we've seen in the past 40 years: the "Black Monday" crash of 1987, two wars in the Gulf, the Asian currency crisis, the bursting of the tech bubble, the 9/11 terrorist attacks, the 2008 financial crisis, and the COVID-19 pandemic.

In every case the global economy didn't end. Broad market indexes recovered – often quickly – and have gone on to new highs.

Don't try to time the market

There are some critical problems with timing the market – the “sell now-buy later” strategy. It means getting two calls right. First, you have to correctly guess when to get out of the market. Then, you have to decide when to get back in, and that’s ideally at the bottom. Wait too long and you can miss out on the market's recovery, leaving you worse off than if you had just stayed the course. Plus, if you cash out, you'll likely interrupt whatever investment plan you put in place before giving it time to work.

The reality is that no one, not even professional investors and money managers, can precisely predict when to get out and back into a market. Rather than market timing, history teaches us it's time in the market that counts.

Equities rise, but when they do it's rarely at a steady pace. Stocks can move sharply higher in just a few days or weeks and then flatten out for much longer. If you happen to miss out on the market's best days it can seriously impact your returns. This is the risk market timers face.

Resist the temptation to time the market and instead just stay invested, through the good times and the bad.

Dollar-cost averaging: invest regularly through thick and thin

Volatile markets could occur more frequently in the future than they have in the past. In our increasingly connected, globalized economies, investment capital can quickly shift from region to region and bounce between asset classes. Speculators drive short-term market movements and commodity prices sway to the fortunes of emerging economies.

Having a disciplined investment plan lets you take advantage of market ups and downs while helping you keep your emotions in check. Putting a fixed amount into the market at regular intervals lets you buy less when assets are pricey and more when they're cheap.

This process of dollar-cost averaging turns volatility from foe to friend. And if you stick to a regular investment program you're less likely to put all your money into what might turn out to be a market top.

Emotions of fear and greed can take financial markets too high on the way up (bubble) and too low on the way down (crash). When a herd mentality emerges it's tough to move in the opposite direction. We might feel safety in numbers, but the crowd's often wrong. In a volatile market your emotions will be hard to resist and it can be difficult to know what to do next.

Regardless of what's happening around you, remember you're an individual with unique goals, lifestyle, and income needs. An investment professional can help you make sense of it all. They'll review your situation objectively and can help build a strategy that not only meets your long-term financial goals, but one you can stick to through changing markets. And when important events happen, they can help you adjust and execute your plan.