From time to time, Morningstar publishes articles from third-party contributors under the "Perspectives" banner.
Here, Brian Doe, a wealth advisor at Gratus Capital Management in Atlanta. writing for AdviceIQ, talks about how emotions affect an investor's judgment ability and how to reduce their role in investing. AdviceIQ delivers quality personal finance articles by both financial advisors and AdviceIQ editors.
The article first appeared on Morningstar.com, our sister US site.
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Buy low, sell high--easy right? Actually, easier said than done. Most of the time investors do the opposite. How can they fix this tendency?
First, realize how widespread the mistake is. Just look at mutual fund flow data, and you will see that equity funds hit their peak outflows at market bottoms and peak inflows at market tops. The same thing applies to bond funds.
Why do investors repeatedly prefer buying high and selling low? The culprit is emotion and when it enters the picture, good judgment leaves the scene. While there are many scenarios where emotions can cloud your judgment, I will focus on three.
Market cycles
Markets rise and fall. We fall in love at the top and we despair at the bottom. The joy of the rise never equals the pain of the fall and we are left feeling bad. Feeling bad does not help us make wise choices.
When a market tsunami washes ashore, you may not want to be the first person on the scene, but selling out and running away can cost you. We experience these events with high intensity and that triggers irrational behavior. Since it’s too late to avoid the drop, now would be a good time for reflection.
Back up and look at the long-term growth charts. The crises were all temporary. Not one provided a good opportunity to sell, even if it did not feel right at the time to stay invested.
Hot tips and too good to be true
Internet chatter, TV talking heads, cocktail party bragging. Bad advice is everywhere.
Over the past decade, I was personally presented with two hot investments that went on to make headlines. My sense said both sounded too good to be true. One turned out to be a Ponzi scheme and the other was for offshore certificates of deposit with impossibly high yields. The leaders of both are now in prison.
I saw smart people take the bait and lose everything. Whether it’s a true huckster or your brother-in-law suggesting you invest your individual retirement account into his micro-brew franchise, you need to be able to back away and assess the situation.
Sentimental attachment
Some investments have been in the family for years and others you accumulate yourself. Either way, it’s easy to get attached to them.
It is easy to believe that nothing will go wrong with that gem of a company that made you rich. Actually, the list of disasters is long and humbling, particularly if you experienced one of them.
Don't fall in love with a corporation. There is a good chance it may not love you back.
So here are two steps to take to protect yourself:
Develop in Investment Opportunity Filter.
You must remain calm and make smart decisions in good times and bad. No matter how magical something sounds, you need an evaluation tool.
On an ordinary day, when nothing significant is happening, take the time to develop your own investment opportunity filter. Define what makes a good investment and a bad one. When opportunity knocks, rate it based on the criteria you established. Here are some suggestions:
Is the investment...
Simple or complex | Liquid or illiquid | Tax-advantaged or taxable | Asset-protected or not Low-cost or high | Guaranteed or variable | Low-risk or high | Good for you or good for your broker
Does it provide...
Control or restrictions | Growth or potential loss
No investment is likely to be perfect, but some are better than others. Some meet your needs and others don’t. Take a moment and find what works for you.
Make Smart Decisions.
Avoiding a few bad mistakes can do more for your wealth than making one excellent bet. Some people out there get lucky, but far more who became millionaires did so by developing good habits around money early in life. That serves them better than any hot tip.
It’s easy to believe that wealthy people are either geniuses or have access to secret information. You hear about those cases because they are exceptions. This is called survivorship bias: It focuses on the few that made it and ignores the many who did not.
Don’t be afraid to delegate. It is far easier to be rational with other people’s money and a good professional can help. Once it becomes personal and emotional, the brain responds differently.