Actively monitoring the investment portfolio is very important to control the changing trends of the financial market. Nevertheless, it is also important for individual investors to manage the impulse of emotional trading, which may come from following the rise and fall of the market. In fact, investors seem to have a knack for investing at the top of the market and selling at the bottom. It is not uncommon to buy investments during peak periods and sell during low cycle periods because they are caught in media hype or fear.
How can investors navigate volatile markets while maintaining stability and maintaining a diversified portfolio to obtain the best overall return in all types of market environments? The key is to understand the motivation behind emotional investing and avoid the euphoric and frustrating investment traps that can lead to decision errors.
- Investment based on emotions (greed or fear) is the main reason why many people buy at the top of the market and sell at the bottom of the market.
- Underestimating the risks associated with investment is one of the reasons investors sometimes make sub-optimal decisions based on sentiment.
- During periods of market volatility and rising interest rates, investors often transfer funds from higher-risk stocks to lower-risk interest-rate securities.
- Average dollar cost and diversification are two methods investors can implement to make consistent decisions that are not driven by emotions.
- As an investor, persisting through short-term fluctuations is usually the key to long-term success.
Pursuing performance will cost you
Investor behavior has always been the focus of many studies, and many theories try to explain the regrets or overreactions that buyers and sellers often experience with regard to money. The reality is that in times of stress, investors’ psychology can overwhelm rational thinking, regardless of whether the pressure is the result of excitement or panic. Adopting a rational and realistic investment approach-taking advantage of market developments that are excited or fearful in a seemingly short period of time-is essential.
In order to obtain returns, non-professional investors usually use hard-earned cash for investment. Nevertheless, they will find that their investments sometimes depreciate due to market developments. Loss can lead to stress and guesswork. In other words, many investors have relatively low risk tolerance when investing because losing money is painful.
“I think a lot of people tend to equate their self-worth with their income, or they think that social media these days pressure people to look better than they do. Because of this, people feel bad ,” said Amy Morin, editor-in-chief of Verywell Mind.
But risk can be seen as a signpost for investment and investor behavior. Investors who invest with a basic understanding of the risks involved can alleviate a lot of emotions associated with the investment. In other words, when investors see unknown or higher risks than they initially identified, the challenges posed by emotional investing will arise.
Bull market and bear market
A bull market is a period when the market rises relentlessly and sometimes indiscriminately.When the bull market is raging and investor sentiment is generally high, investors may see market opportunities or learn about investments from others (such as news reports, friends, colleagues, or family), which may force them to test the waters. Excitement may cause investors to try to profit from investments that arise due to bullish market conditions.
Similarly, when investors read reports about economic downturns or hear about volatility or negative market periods, their fear of investment can encourage selling. Bear markets are always lurking around the corner with many warnings of their own. These warnings are important to investors and can be followed and understood.Contrary to bull markets, sometimes financial markets may continue to fall for months or even years.
Bear markets usually evolve from an environment of rising interest rates, which can stimulate risk-averse transactions and the transition from higher-risk investments such as stocks to low-risk savings products. When investors see their stocks depreciate and safe-haven assets become more attractive due to rising returns, bear markets can be difficult to navigate. During these periods, it is difficult to choose between buying stocks at market lows or buying cash and interest-bearing products.
Emotional investment is usually made in bad market timing. Paying attention to the media may be a good way to detect when a bull market or a bear market evolves, because daily stock market reports will vary according to the activity that takes place on the day, which sometimes attracts investors’ attention. However, media reports can also be outdated, short-lived, or even meaningless reports based on rumors.
After all, individual investors are responsible for their trading decisions, so they must be cautious when looking for market opportunities based on the latest headlines. Using rational and realistic thinking to understand when an investment may be in the development cycle is the key to evaluating interesting opportunities and resisting bad investment ideas. Reacting to the latest breaking news may indicate that decision-making is driven by emotion rather than rational thinking.
Tried and tested theory
The view that many market participants buy at the top and sell at the bottom has been proven by historical capital flow analysis. Fund flow analysis looks at the net flow of funds in mutual funds and usually shows that when the market reaches peaks or troughs, buying or selling is at the highest level.
Market anomalies like crises may be useful time periods for observation. During the financial crisis from 2007 to 2008, investors withdrew their funds from the market, and the flow of funds in mutual funds turned negative. The net outflow peaked at the bottom of the market, and as is typical at the bottom of the market, the selling created over-discounted investment, which eventually formed the turning point and the basis for the next market rise.
Strategies to eliminate investment sentiment
The two most popular investment methods-average dollar cost and diversification-can eliminate some of the guesswork in investment decisions and reduce the risk of inappropriate timing due to emotional investment. One of the most effective methods is to average the dollar cost of investment dollars.
Average dollar cost is a strategy in which an equivalent amount of dollars is invested at fixed, predetermined time intervals. This strategy can be implemented under any market conditions. In a downtrend market, investors buy stocks at lower and lower prices. During an uptrend, the previously held shares in the portfolio are generating capital gains, and because the dollar investment is a fixed amount, fewer shares are purchased when the stock price is higher.
The key to the dollar cost averaging strategy is to stick to it. Develop a strategy and don’t tamper with it, unless major changes require revisiting and rebalancing the established course. This type of strategy is most suitable for 401(k) plans with matching benefits, because a fixed dollar amount is deducted from each salary and the employer provides additional contributions.
The total fund assets in the 401(k) plan on December 31, 2019 accounted for nearly 20% of the total mutual fund assets.
Diversification is the process of buying a series of investments rather than just one or two securities, and it also helps reduce emotional responses to market fluctuations. After all, there are only a few times in history that all markets have gone hand in hand, and diversification provides little protection. In a normal market cycle, the use of a diversification strategy provides a protective factor, because the loss of some investments will be offset by the gains of other investments.
Portfolio diversification can take many forms, such as investing in different industries, different geographies, and different types of investments. It can even be hedged through alternative investments such as real estate and private equity. The unique market conditions that benefit each of these investment groups, so an investment portfolio composed of all these different types of investments should provide protection under a range of market conditions.
Frequently asked questions
Why is emotion so important to market psychology?
Many investors are emotional and reactionary. Fear and greed are the top priorities in this field. According to some researchers, greed and fear have the ability to affect our brains in some way, forcing us to put aside common sense and self-control, and thus trigger change. When it comes to people and money, fear and greed can be powerful motivations.
How to measure the degree of fear or greed in the stock market?
There are several market sentiment indicators that can be viewed, but two specifically ask about emotions of fear or greed. For example, CBOE’s VIX index measures the level of fear or greed implicit in the market by looking at changes in the volatility of the S&P 500 index. The CNNMoney Fear and Greed Index is another great tool that can measure changes in fear and greed daily, weekly, monthly and yearly. It is used as a contrarian indicator, checking seven different factors to determine how much fear and greed exist in the market, and scoring investor sentiment on a scale of 0 to 100.
What trading strategies can control emotions?
Making an investment plan and sticking to it is the best course of action to avoid being affected by emotions in trading. Passive index investing, diversification, and average dollar costs are all fairly simple ways to maintain objectivity.
Emotionless investment is easier said than done, but there are some important considerations that can prevent individual investors from chasing futile gains or over-selling in panic. Understanding your own risk tolerance and your investment risk can become an important basis for making rational decisions. Active understanding of the market and the forces driving bullish and bearish trends is also crucial.
Overall, although positive and emotional investments can sometimes be profitable, the data shows that following a clearly defined investment strategy and sticking to it amidst market volatility usually brings the best long-term performance returns.