Keeping your investment emotions in check

Friday, July 2, 2010

Few would dispute that these are trying times for investors. Consider, as we often do, the recent volatility in the financial markets caused in part by concerns about the European debt crisis and the fate and extent of financial reform in Congress.

To use one simple barometer, beginning in February the Dow Jones began a surge upward through late April to 11,205 — whereupon it began a drop through May 20 of greater than 1,000 points and landed pretty much where it began in early February.

I said that market volatility was caused, in part, by reasons often explained in the headlines. But what the headlines predictably neglect is a crucial component in the volatility equation — namely, human fallibility driven by strong emotions.

Ideally, emotions should be kept in “check” when making any long-term investment decisions. But saying that is much easier than doing it, especially when the market is a rollercoaster and your own money is at risk.

It’s only human to let emotions take hold during testing times like the current financial crisis. Yet emotions can often lead one to derail when staying on the tracks would help us most.

Market trends come and go and veer up and down. Keeping a level head, while not easy, is imperative. My background in psychology and behavior has trumped my financial training numerous times, and I always emphasize the importance of having a strong historical perspective.

Here’s an analogy we often use. We each have bullish and bearish parts of our investment character and how we handle, balance and understand those parts often determines the success of our long-term strategy. And though markets are efficient over time, short-term bubbles and manias can be highly emotional events.

The opening lines of the Rudyard Kipling poem, “If,” still apply: “If you can keep your head when all about you are losing theirs ….” Study after study have revealed that investors often undermine a sensible investment strategy by getting caught up in short-term market mania — buying high when the market is rising and selling too low on the downslide.

In my experience, investors feel very bullish, perhaps too much so, about their investments during bull markets. However, momentum investing can be an expensive trap — we call it betting on a favored horse after the race has been run. We’ve seen too often where the market can shift dramatically and the seemingly sure-bet bull investment can vanish quickly — which could prompt the even riskier strategy, one common in gambling halls and with bookies, of “chasing losses” to make up for the original sure-bet investment.

Make no mistake about it — the emotions we feel during bull and bear markets are very real, sometimes intense, and range from euphoria to desperation, from optimism to denial and from fear to acceptance.

After all, this is our hard-earned money that we have set aside to provide for our financial security. Dealing with one’s emotions requires education and preparedness to ride out the frequent storms.

It seems obvious, but one of the vital tasks of an experienced adviser is to provide clients with a framework of historical understanding about how investment strategies work over the long term. This isn’t a cookie-cutter approach. It is a very personalized assessment of one’s risk tolerance, of understanding one’s political and cultural biases and particularly defining one’s financial security goals — in essence, learning how to “know thyself” as an investor.

A wise long-term investment strategy maintains a strong vision and assumes that change is a constant. Sound structure and a unique allocation of assets offers an alternative to letting emotions make our decisions.

After all, Noah didn’t wait until it was raining to build his ark.

Tom Sedoric, managing director-investments of the Sedoric Group of Wells Fargo Advisors in Portsmouth, can be reached at 800-422-1030 or tom.sedoric@wfadvisors.com.


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