Being rational can be hard when it comes to managing money. In a perfect world, every investor could “buy low and sell high”—however, the realities of markets often prove more complex, and require a more measured approach.
Take losses, for example. When your portfolio value falls sharply, you may hold a declining investment, hoping the price will rise again—at least up to the price you paid so you can break even. This kind of loss aversion can prevent you from taking the right steps for sound portfolio management.
On the other hand, when markets are boisterous, overconfidence can prompt you to ignore diversification, or trade too often. It can prevent you from paring your winners when markets are too frothy, and set you up for losses when your “winning” securities reverse course.
Whether your investments are increasing or decreasing in value, your emotions can steer you in the wrong direction.
The Emotional Toll on Your Portfolio
Buying and selling—or selling and then buying—in the hope of catching higher returns is a common investor foible. And in large part, emotions explain why investors consistently underperform the markets. The difference, sometimes called the “behavior gap,” adds up over the years. For example, over a ten-year period ending in December 2017, the typical fund gained an average of 0.72% more than the typical investor each year—leading to a cumulative average shortfall for the investor of 13.3% for the ten-year period.
Source: Schwab Center for Financial Research with data from Morningstar, Inc. Fund return is the weighted average time-weighted return of all active funds in the Morningstar domestic equity, specialty, and international stock categories. Each fund is represented by its oldest share class. Investor return for each fund is calculated by Morningstar and reflects the average return on all dollars invested based on estimated monthly net fund flows. The aggregate investor return and fund return are averages weighted by the size of each fund. Only funds with both the fund return and the investor return are included in the analysis. Past performance is no indication of future results.
Choosing, implementing, and maintaining a well-thought-out investment strategy can help you avoid some common investment mistakes. In fact for decades, academics who study the intersection of psychology and money—a field known as “behavioral finance” —have argued that if investors could only remove emotion from their financial decision-making they would stand a better chance of reaching their long-term goals.
But on a personal level, ignoring your natural responses to market gains or setbacks can be as challenging as giving up sweets or sticking with an exercise program.
What You Can Do Next
Your emotions might still surface when you think about money, but you can avoid being ruled by them. If emotions interfere with how you choose and manage your investments, consider a robo-advisor.
- Schwab Intelligent Portfolios® provides an automated investing platform that could help you to skirt your personal biases and emotional reactions.
- If you prefer more personalized guidance, consider Schwab Intelligent Portfolios PremiumTM. A CERTIFIED FINANCIAL PLANNERTM professional can help you fine-tune your financial plan.
- Call us at 800-355-2162 or visit your local branch to discuss all your options.