Staying in control: How to avoid emotional investing

With a decade of robust investment performance behind it, markets started 2020 riding that momentum to new record highs. Pockets of volatility sprung up throughout the past 10 years, but it's been smooth sailing for the most part. Investors have been treated to an unusually long period of smooth, positive equity markets — and it's easy to forget that volatility is normal and a sign that markets are actually functioning correctly.

Well volatility is on rise again, the latest round being sparked by the coronavirus (COVID-19) outbreak. Global markets have taken a hit processing the impact the virus could have on businesses around the world.

With all the headlines, it's important to remember that your MD Portfolio was designed to achieve your long-term financial goals with respect to your comfort level with risk and volatility. For client portfolios following MD Financial Management's (MD) tactical asset allocation advice, adjustments have already been made in response to changing market conditions. As always, MD will continue to analyze the situation and make appropriate adjustments if needed.

Stay focused on what you can control

Market volatility can be uncomfortable — many investors feel like they can't control it and want to avoid it. It's important to focus on things that can be controlled, like developing an investment plan that minimizes risks while being able to achieve your financial goals, rather than the fluctuations of the market.

Being uncomfortable can often cloud investment decisions with emotion. Fear and greed, not market movements, are usually the greatest risks to not achieving long-term financial objectives. While you can't ignore your emotions, understanding the root of those emotions can help you channel them more productively in times of emotional uncertainty.

On that note, here are some common investing pitfalls that are often driven by emotion and the best ways to avoid them.

Pitfall 1: Selling low, buying high

This behaviour is obviously counter-productive, but many investors do it unwittingly. As humans we are hard wired to avoid losses. This concept is known in behavioral economics as “loss aversion" and was popularized in 1979 by psychologists Amos Tversky and Daniel Kahneman. Essentially, the human tendency is to strongly prefer avoiding losses over acquiring gains because losses can have twice the psychological impact.

Loss aversion isn't always a negative, as it could prevent investments that could be harmful to your financial health. However, often when markets decline, many investors feel the emotional need to sell their entire portfolio, hoping to avoid further losses. These same investors reason that they will buy back in when markets rebound.

Unfortunately, it's very difficult to predict when to get out and when to get back in — putting you at risk of missing the best trading days and not being able to achieve your financial goals.

The cost of missing the best days on the S&P 500 (1990-2019)

The risk is real—annualized returns can be dramatically impacted.

Chart showing the cost of missing the best days on the S&P 500

Source: Bloomberg

History has shown that staying invested increases the chance of success over the long term. Staying invested in a portfolio with proper asset allocation and not market timing will account for the majority of that success and can allow you to avoid selling low and buying high.

Pitfall 2: Focusing on the headlines

Media headlines are not indicators on which to base an investment strategy —the media wants you to consume the content, which often means framing stories in ways that generate interest. For example, you might be tempted to chase performance by buying the latest trending investment touted on business television or selling your investments all together because the newspaper exclaims the market is “crashing."

Rather than focus on the daily headlines, keep your long-term investment goals in mind. Over the long term, we know markets will have more up days than down. We also know that they tend to fall harder than they gain, they just fall less frequently. Short-term market news can be a distraction that causes unnecessary emotional turmoil and could be detrimental to your long-term investment goals.

Keeping focused on your long-term investment goals can lead to an increased feeling of emotional security and ultimately allow you to make better investment decisions.

Markets over the long-term: Growth of $10,000

The general long-term trend for markets is up, regardless of current headlines.

chart showing long term growth from 1991 to 2020

Source: Thomson Reuters

Pitfall 3: Ignoring diversification

One way to help minimize risk in your portfolio is to diversify your investments. Having a portfolio with the appropriate mix of investments can protect it from risks specific to a particular company, industry, market, economy and / or country. Diversification is a key component of a portfolio designed to perform through the entire market cycle and not just over the short term.

Holding a diversified investment portfolio is the most sensible way to fund the investment goals that are important to you but it may not provide the same emotional thrill or cocktail fodder as a concentrated portfolio of “hot" investments. Don't give in to this emotional trap as over the long term the only hot investment needed to get you to achieve your investment goals, is a diversified portfolio.

The benefits of diversification

Different investments perform at different times. A diversified portfolio can smooth out performance.

Asset class returns presented in Canadian dollar terms.The diversified portfolio is an equally weighted portfolio of the 6 other asset classes.

Source: Thomson Reuters

Pitfall 4: Not speaking to your advisor

It can be stressful when you miss an investment opportunity or when the markets move negatively. An advisor can provide the experience, perspective and level-headedness to help filter out the daily noise and allow you to stay on track over the long term.

Additionally, they can help you construct your goals and investment strategy if needed and ensure you are adequately diversified. A review with your advisor can give you the opportunity to revisit your plan, ask questions and reassure yourself that you're on the right path despite fluctuations in the market.

Pitfall 5: Setting unrealistic expectations

After a prolonged bull market run, we often have to remind ourselves that markets don't only move up, they move down as well and that both are part of a normal and healthy market cycle. In fact, stock market corrections happen on a pretty regular basis. For example, the S&P 500 experienced double-digit pullbacks in 19 of the last 38 years since 1980. Of those 19 years, the market ended the year with a positive return 12 times. In times of financial stress it is easy to lose perspective on how markets work.

Similarly, in times of bullish market sentiment, it's easy to forget that a diversified portfolio designed to reduce risk while achieving the performance needed to meet your financial goals, won't likely perform as well as the latest speculative investment story or often even the general market for that matter during a full manic bull market. The flip side of that same portfolio though is that it will likely protect you better on the downside.

While emotionally it may seem reasonable that your portfolio will capture all of the upside, while avoiding the entirety of any decline, in practice, this is an unreasonable expectation that can lead to poor long-term decision making.

We are here to help

While we can't predict with 100% accuracy what will happen with the markets, we can take steps to prepare ourselves. Before you make an investment decision based on your emotions and the latest market noise, stay calm, remember your long-term financial goals and take comfort in knowing your MD Advisor* is here to help if you need to talk about it or have any questions.

* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).

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