First and foremost, what is emotional investing? There are various opinions and beliefs as to what emotional investing is, but most of the definitions center around fear, greed, and hope.
These three emotions are part of human nature, but an investment decision shouldn’t be made on them. Rather, an investment decision should be made on either technical analysis, fundamental analysis, or a combination of both!
Why Is Emotional Investing Dangerous
Emotional investing is so dangerous for a variety of reasons! As candid as this sounds, it doesn’t matter if you’re investing in stocks, bonds, foreign exchange, commodities, or real estate; the underlying investment doesn’t care about your emotions, nor does it care what price you purchase the asset for.
Here are some common emotional investing traps.
- Emotional Investing With Greed – It’s easy to become greedy when making investments, and when greed kicks in, so does emotional investing. Consider this example; you purchased stock ABC for $100 a share. You initially purchased this company based on strong technical analysis, and you predicted the price would rise to $115 a share in the next 60 days. Fast forward and the stock is now trading at $135 a share, above and beyond your initial expectations. You’ve decided to hold onto your investment and are beyond happy with the profit you earned. However, you are now in unchartered territory, and you’re unsure where the stock will run to next. Unless you have a plan to sell, you’ve let greed overpower your investment decisions, and this could be very dangerous.
- Emotional Investing With Fear – Another variable to consider is when one is fearful in the market and that fear overpowers their investment decisions. If you’re constantly afraid that the asset will decline in value, you may make pre-mature selling decisions, ultimately leaving too much-unrealized profit on the table.
- Emotional Investing With Hope – Hope is a word that never belongs in your investing strategy or decision-making process. An example of investing with hope is when you purchase stock ABC for $100 a share, expect it to rise to $115, but it declines to $85 instead. Now you are left unsure what the future has in store for that specific stock, and you’re left hoping the price reaches $100 again just so you can break even. If a stock goes in the opposite direction of your prediction, you need to have a well thought-out plan as to what your moves are going to be.
How to Avoid Emotional Investing
Now with a better understanding of what emotional investing is, how can you possibly avoid emotional investing? Before diving into tried and true ways to avoid emotional investing, it’s important to mention that even professional money managers fall victim to emotional investing at times.
It’s incredibly challenging to fully manage your emotions, but becoming robotic with your investing and trading decisions is needed for long-term success.
Success seldom happens without plans. Knowing you want to invest or trade isn’t a plan, that is simply the action. You must plan each investment and trading decision carefully. Your plan should cover a few different areas.
- What will you be investing in and why? If you want to invest in stocks, that’s fine, but why not invest in foreign exchange? By no means are we suggesting foreign exchange is superior to stock investing, we’re just simply making a point that you should know exactly why you want to invest in specific asset classes before you actually invest in such class.
- Beyond that, you must analyze where you expect the price of the underlying asset to rise or fall to during your investment period. This is generally completed in two different ways:
- Fundamental Analysis – This is when the investor looks at the business’s fundamentals, such as the P/E ratio, earnings per share, future outlook on the business, and the revenue and margin performance. Factoring in all of these variables can help an investor determine if they believe the asset is currently priced properly, overvalued, or undervalued. From there, the investor will make an investment decision.
- Technical Analysis – This is when the investor or trader leverages technical analysis to determine where they believe the price of the asset will be at a later point in time in the future. Technical analysis looks at volume, volatility, historical performance, patterns, and price movement.
- Now that you’ve isolated what investment class you’re going to invest in, and what analysis technique you plan on using, it’s now time to create the A/B plan.
- If the price of the asset increases, what price will you sell your shares for? For example, following the ABC example from above, if you believed the price per share would reach $115 and is now trading at $125, when do you plan on selling your shares?
- If the price of the asset decreases, at what point do you plan on selling your shares? Perhaps you are willing to lose 3%, 5%, or 10% of your investment before selling. It’s entirely up to you and your risk tolerance, but you should have a pre-determined sale price that you stick to if the investment moves in the opposite direction.
Managing Your Emotions Is Tough
Emotions belong in so many important life decisions. However, investing isn’t one of them.
Controlling emotions while investing is incredibly challenging to do, but it is also incredibly important you do so properly. If not, emotional investing can cost you a great deal of money.
The best way to make sure you’re taking the right approach to your investment decisions is to work with a professional financial advisor. Financial advisors can help you plan your investments, manage your risk, and develop your buying and selling plan.
Additionally, financial advisors will help you create a financial plan that is all-encompassing, including a budget, savings plan, ensuring you are putting enough money away for your long-term goals or future expenses.