A recent study by DALBAR found that individual investors averaged a 3.69% annual return over a 30-year period in which the S&P 500 averaged 11.1% returns annually. Do you know why? It is because the biggest hurdle most people face when making investment decisions is their own emotions. Many people make emotional decisions regarding when to buy or sell. Oftentimes they make the wrong decision, because it is hard to remain objective while selecting options for their own money. Here are some ideas for controlling emotions when making investment decisions.
Know Your Risk Tolerance
Only one person can tell you how risk averse you are regarding your money–you. It is essential to know what type of investor you are, whether a beginner or one who has a good understanding of the stock market. You may be a conservative investor when you exit your fellowship, but you may evolve into a moderate or aggressive investor after gaining more knowledge.
It is beneficial to take a risk assessment questionnaire every few years to measure your comfort level with the overall risk of your portfolio. It is easy to consider yourself an aggressive investor when the stock market is gaining consistently, but it can be scary when the market takes a dive. Whatever you decide, make sure that you can stomach the volatility of the markets without making rash decisions concerning your investment portfolio.
Education is a Key Factor
The more informed you can become about investing, the easier it will be to make rational decisions about your investment strategy. Knowledge of the basic concepts of investments helps to prevent knee-jerk reactions after a bad day, month, or year in the market. Do you know the difference between a stock and a bond or an exchange-traded fund (ETF) and a mutual fund?
Do you understand the concept of asset allocation? Such knowledge is useful for making decisions based purely on facts. Without a grasp of the basic jargon, it is easy to get caught up in the media frenzy and to completely give way to emotion-based decision-making.
Concentrate on YOUR Goals Only
Have you ever been in a conversation in which someone tells you how much money they made in their retirement account at work, and you begin to think about your own portfolio’s performance? Did you ask yourself, “Why did their account increase more than mine? Maybe I should change my allocation?” This way of thinking completely abandons rational thought.
If your goals are such that your long-term growth rate only needs to be 7%, then allocate your money to give yourself the best chance to meet this objective. There is no reason to take on risk or volatility that exceeds your needs and comfort level. Financial advice is only important when it is specific to YOU. Generic advice can cause confusion more often than not. Always concentrate on your goals and not those of others.
The Tortoise Always Beats the Hare
I challenge you to consider the long term when making investment decisions. The more time allotted to achieve financial goals, the greater the chance of success. The following formula explains how money grows: FV = PV (1 + i)
The variables are future value of money (FV), present value of money (PV), interest (i), and time (N). According to basic algebra, the only important variable to focus on is N. Time is money. Investors who allocate investments appropriately and leave money to grow over a long period of time will be ahead of the game. Those who are armed with this knowledge tend to be less emotional when making decisions about their money. Emotional decisions can hurt investments.