COVID-19 has caused a lot of volatility in the stock market, causing a stirring of emotions, including fear among even the most experienced investors. It is hard not to get panicky when you see your portfolio plummet 30%. Investing is an emotional game. The reality is that the investor's mind can overpower rational thinking during times of stress, and it can lead us to make some terrible financial choices when we let our emotions take control.
To avoid our feelings overriding we can put systems and rules in place for when and how to invest, and when and how to exit an investment, so you as an investor can remove your emotions as much as possible and begin to maximise returns.
How can you take emotion out of investing and stay on the path to achieving your financial goals?
The key is to understand the motivations behind emotional investing and to avoid both elated and depressing investment traps that can lead to poor decision-making.
Use news as information and not to make decisions
There are certain parts of investing that are within our control and others that are not. By using the market news as information, so you are aware of what is going on but resisting using it to make decisions and over-monitoring your portfolio.
By checking your portfolio on a monthly or quarterly basis you will be better able to keep emotion in check and stay focused on your financial goals.
Evaluate and rebalance
When a financial recession or crisis happens, it offers an opportunity to take stock and assess the makeup of your portfolio to see if any changes need to be made according to your risk profile or if there has been any changes in your financial goals. For someone that is planning to retire in the next ten years, your portfolio may be too heavily weighted in stocks. You may need to rebalance this with bonds or another form of steady cash flow that is less risky. It does not equate to selling your shares now but will make you think about financial decisions you need to take down the line.
During periods of market volatility, it can make investors more cautious and often result in movings funds from riskier stocks towards investments that are too conservative such as lower-risk interest rate products. Which could be a mistake as for most people taking on some risk is critical to generating enough growth to achieve goals and protect wealth from inflation.
Look back in time
It is reassuring to know that in all previous financial crisis' and world events that the markets have always recovered and resumed their advance. Although we cannot rely on history repeating, it does provide a signal that the longer the time horizon you have, the more likely you are to have overall positive returns. To illustrate, below is the five-year S&P 500 index (US 500 largest companies), as you can see over the last five years, there has been ups and downs in the index but an overall upward trend.
S&P 500 Index - 5-year price movement
Don't try to time the market
Growing the value of your investments is all about time in the market and not timing the market. Resist the temptation to time the market and instead stay invested, through the good times and the bad. Timing the market means that you have to correctly guess when to get out of the market and then decide when to get back in, ideally at its lowest.
Dollar-cost averaging and diversification are two approaches that investors can implement to make consistent decisions that are not driven by emotion.
Dollar-cost averaging
Dollar-cost averaging is when you choose to invest a certain amount regularly, regardless of what the price is. With dollar-cost averaging, when prices are high, you will end up with fewer stocks, but when prices are low, you will end up with more, smoothing out the money you invest when the price is more than average. This investment technique favours long term investing and removes much of the detailed and expert work of attempting to time the market to make purchases of shares at the best prices.
Related article - Dollar-cost averaging - When is the right time to invest
Diversification
You cannot predict returns, but you can predict and manage risk, which makes a diversified portfolio your best defence against a financial recession. Diversification means building an investment portfolio that is made up of many different types of investments that behave in different ways to the market.
By managing and spreading risk, it reduces your exposure to the risk of any single one of your investments, providing disappointing returns. Even better, when performed correctly, it reduces your risk without decreasing your expected returns.
Related article - Diversification - Achieving the highest return for the lowest risk.
In summary,
Investing without emotion is easier said than done, but as discussed, some key considerations can keep an investor from letting their feelings making their money decisions.
A regular and automatic investment plan no matter what the state of the market, will teach you a non-emotional approach and keeps your plan on track even when you get distracted. It is also essential to understand your risk tolerance and the risks of your investments so you can have an idea on what to expect when the next recession happens (Related: What type of investor are you?).
Information provided by goBuoyant is general in nature and does not take into consideration your personal financial situation. It is for educational purposes only and does not constitute formal financial advice. Remember, the value of any investment can go down as well as up.
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