Avoid the Emotional Investing Trap

October 4, 2022
Far too often, investors focus on the current hot stocks or investment fads and take on more risk in their investment portfolio than is necessary to achieve their financial goals.

"The investor's chief problem—and even his worst enemy—is likely to be himself." – Benjamin Graham, economist and author of The Intelligent Investor

Graham's quote is as true today as when he began his storied investment career more than a century ago. He spoke from experience, having learned valuable investing lessons from the 1929 stock market crash. Investors today continue to be lured into pitfalls such as performance chasing and market timing that can throw them off track from their financial goals.

Far too often, investors focus on the current hot stocks or investment fads and take on more risk in their investment portfolio than is necessary to achieve their financial goals. The result is that they frequently become overconfident when markets are rising and then panic when markets are falling. The first half of 2022 brought a stark reminder that financial markets can be volatile and unpredictable.

Overcoming common behavioral biases

One of the biggest mistakes that investors make when markets turn turbulent is to view short-term declines in their portfolio as "losses" rather than the natural ups and downs of financial markets. Short-term declines are only paper losses and retain the potential to recover unless the investments are sold and become realized losses. Investors who have succumbed to the behavioral bias of overconfidence often resort to market timing during market corrections and end up mistiming moves out of and then back into their investments.

Investors can also let fear cause them to be too conservative within their portfolio and miss out on potential long-term growth. For example, many investors stayed on the sidelines after the 2008–2009 financial crisis and missed out on some or potentially the entire bull market that followed and lasted more than a decade.

These kinds of timing mistakes can be highly detrimental to long-term performance and throw investors off-track from their financial goals. For example, the Schwab Center for Financial Research found that timing mistakes caused the average mutual fund investor to underperform the average mutual fund by more than one percent per year over the 10-year period ended Dec. 31, 2021.

Be aware of common behavioral biases

Psychological responses to investment gains and losses are inevitable due to human nature. Behavioral biases include both emotional biases (how you feel about something) and cognitive (how you think about something) biases. Awareness of these can help you prepare for and recognize them so that you can avoid their traps. Some of the most common behavioral biases include:

Emotional biases

  • Regret: Fear of taking action due to the regret of previous mistakes or failures
  • Loss aversion: Playing it too safe with regard to risk; selling too soon or at the worst possible time
  • Overconfidence: Being overly or unjustifiably confident in one's own ability

Cognitive biases

  • Anchoring: Getting stuck on a specific point of reference when measuring investment performance (e.g., a portfolio's past high)
  • Selective memory: Tendency to remember positive outcomes over negative outcomes
  • Herding: Following what everyone else is doing; leads to "buy high, sell low"

Figure 1 provides an example of a hypothetical investor and the common emotions at various points as financial markets move up and down over time that can potentially cause you to let emotions dictate your investment decisions.

Figure 1: Taking stock of biases. Can you relate?

Example of a hypothetical investor and the common emotions from emotional intuition to faulty reasoning at various points as financial markets fluctuate over time

Source: Schwab Asset Management. Not representative of any specific investment or account.

The example is hypothetical and provided for illustrative purposes only.

Defining your goals and time horizon can help you avoid emotional biases

Clearly defining your investment goals and time horizon are the first steps in guiding you to a portfolio with the right amount of both risk and return based on your individual need. Investment time horizon is just the amount of time before you need to begin spending the money in the account. Most portfolios would typically hold some combination of stocks, bonds, commodities and cash, with the mix determined by your goals, time horizon and both willingness and capacity to take risk.

A bucketing approach is one way to address different time horizons

People typically have multiple financial goals, which could include short-, intermediate- and long-term goals. One way to help invest appropriately for each goal is to take a bucketing approach with a portfolio for each goal. This involves dividing your savings into three buckets: short term (money you expect to need within the next two years); intermediate term (three to 10 years); and long term (10 or more years).

Bucket 1

Short-term goals could include things like current spending needs, a wedding or a nice vacation. Consider more stable investments such as cash or cash alternatives. Putting money you plan to spend soon into liquid, generally low-risk investments can help you avoid having to sell other investments to raise cash in a down market.

Bucket 2

Intermediate-term goals could look like a down payment on a home. With a focus on growth and capital preservation, this bucket could include a mix of assets such as intermediate-term bonds and stocks.

Bucket 3

Long-term goals could include retirement or your kids' college and could be invested for growth and income with a diversified mix of asset classes with an emphasis on stocks.

Digital advice is designed to add discipline and overcome emotion

Digital advice solutions such as Schwab Intelligent Portfolios® are designed to help you invest in a diversified portfolio based on your individual need and keep you on track as you work toward achieving your financial goals. After answering a brief investor profile questionnaire, you receive a recommendation for a diversified portfolio with a mix of stocks, bonds, commodities and cash tailored to your goal, risk profile and time horizon. And, you can open more than one Schwab Intelligent Portfolios account if you have multiple goals.

Your portfolio is then professionally managed using a combination of people and technology that includes features such as automated rebalancing, goal tracking, tax-loss harvesting (if you've enrolled) and automated distributions. These features are all designed to provide a disciplined approach that can help take emotion out of investing to help you avoid some of the common behavioral pitfalls along the way to long-term investment success.

David Koenig, CFA®, FRM®, Vice President and Chief Investment Strategist for Schwab Intelligent Portfolios