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Checking your quarterly 401(k) statement, you get a sinking feeling in your stomach: Your account has lost 20% of its value. Your mind starts racing: Will its value continue to plummet? How will you ever afford to retire? Should you move your money out of the stock market and into safer investments?
With the stock market on a wild ride in the past year, it's easy to lose sight of logic and let your investment choices be swayed by fear, misplaced confidence or other strong emotions. But basing investing decisions on emotion can lead to disappointing results and long-term damage to your financial portfolio.
What Is Emotional Investing?
Emotional investing involves letting emotions, rather than logic, drive your investment decisions. For example, fear of losses could spur you to bail out of the stock market at the first sign of a downturn and miss out on potential gains. Invest too conservatively, and inflation could outpace your investment returns. At the other extreme, past successes could lead to overconfidence that you can "time the market," and prompt risky investments you don't fully understand.
It's natural to feel strong emotions around money. However, investing based on those feelings rarely produces the best returns. Timing the market by purchasing stock at its lowest value and selling at the highest value is challenging for even investing professionals. Stock prices fluctuate constantly, driven by factors including global and domestic political, economic and industry trends that are difficult to predict.
How to Avoid Emotional Investing
Regardless of your goals, timeline or risk tolerance, the following strategies can help you avoid emotional investing and make smarter investment decisions.
1. Think Long Term
While it's important to keep an eye on your investments, obsessing over daily ups and downs can lead to poor decisions. Focusing on the big picture will help you keep things in perspective. On average, bear markets last less than 10 months, Hartford Funds reports. The stock market is inherently volatile, but over the past 100 years, stocks have delivered average annual returns of about 10%. A "buy and hold" strategy—purchasing and keeping investments for the long term—can smooth over market fluctuations if the assets increase in value.
2. Diversify Your Investments
Taking calculated risks can help grow your investments, but risk management is key to creating an optimal portfolio. To make sure that any one loss won't have far-reaching consequences over the long term, many financial advisors suggest diversifying across asset classes. Allocating 60% of your investments to stocks and 40% to bonds is often recommended, but younger investors may want to lean more toward stocks, while older investors might prefer a higher percentage of low-risk investments.
Purchasing mutual funds, exchange-traded funds (ETFs) and index funds can help diversify your investments. These investment portfolios often include holdings across multiple industries, locations, company sizes and types of securities, helping insulate you from dramatic market fluctuations. For example, if your portfolio includes international stocks, you'll be less affected should domestic stocks take a dive.
3. Use Dollar-Cost Averaging
Dollar-cost averaging makes it easier to stay focused on long-term goals and avoid making emotional investment decisions. This strategy is commonly used with employer-sponsored retirement plans in which you make a set, monthly contribution. However, you can also use it outside of these plans using IRAs, brokerage accounts and other investment vehicles.
To really take the guesswork out of investing, try automating your investments. Have your employer take monthly deductions from your paycheck or set up automatic monthly transfers from your bank account. When you don't have to think about making an investment, you're less likely to let emotions drive your decision-making.
4. Consider Costs
When evaluating potential changes to your investments, it's important to look beyond gains and losses. For example, ETFs may charge as much as $25 per trade, and some brokerage accounts impose fees for purchasing and selling stocks. Selling stock at a profit could result in capital gains taxes, too. Robo-advisors can help maximize tax savings by selling poorly performing investments to take advantage of tax-deductible capital losses. Considering the full financial impact of any changes can help keep you from acting impulsively.
5. Get Professional Advice
In addition to managing your investments, a financial advisor or investment advisor can provide an expert's perspective on market fluctuations, helping keep you rational in the face of volatility. Financial advisors are available for all income levels; they're not just for the wealthy.
An even more affordable option is investing using a robo-advisor. These automated investing services typically use online questionnaires to gather information about your investing goals, timeline and risk tolerance, create a custom portfolio specifically tailored for you, and manage it for you. Just be aware there's no human interaction, which could pose challenges when you need a little emotional reassurance.
Factors to Consider When Rebalancing Your Portfolio
While you shouldn't make impulsive investment moves based on your emotions, you should rebalance your portfolio from time to time to support your financial goals. In the long term, you'll generally see higher returns on your investments if you take a logical approach that considers the following factors:
Your Financial Goals
Are you investing for long-term objectives, such as retirement or your newborn child's college fund, or short-term goals, such as buying a home? Different goals require custom tailored investing strategies. In general, money needed within 10 years should be invested in more conservative assets, while longer-term goals have more time to ride out changes in the market and can benefit from more aggressive investments.
Your Age
Your age and retirement timeline also affect your investment strategy. In general, younger people can make higher-risk investments because they have plenty of time to make up any losses before retirement. As the years pass, however, shifting investments into more conservative assets can help protect your capital while taking advantage of growth opportunities. Target-date funds (offered by many 401k plans) adjust investments automatically based on your age, helping to ensure that your investment strategy adjusts as retirement nears.
Your Risk Tolerance
Everyone has a different appetite for risk. Whatever your age, your investment strategy should allow you to sleep at night. Earning a reasonable return on investments requires balancing risk and reward, but whether your approach is aggressive or conservative, the right mix of investments can help provide both growth and security.
The Bottom Line
There's no one-size-fits-all answer when it comes to investing. Ultimately, however, keeping the big picture in mind and investing for the long term can generate a better return on investment than an emotion-driven approach.
While you're taking a logical approach to investing, get serious about other aspects of your financial life, too. Start by checking your credit report and credit score and taking steps to improve your credit score if necessary. Making a budget, building a solid emergency fund and paying down high-interest debt are other financial moves that can help you sleep more soundly at night, no matter how your investments are doing.