Wednesday, May 2, 2012

Don't let emotions drive your investment decisions

Remember August 8, 2011? That's the day the Dow Jones Industrial Average fell more than 600 points after the first-ever Standard & Poor's downgrade of U.S. debt. The Dow's one-day drop was its biggest point loss in a single day since December 1, 2008, and the sixth biggest point drop in its history. On that day the Dow closed down 634 points (5.6%) to 10,810. That single day's decline in stock values wiped out about $2.3 trillion in investor wealth in the U.S. What happened to investors who panicked and sold their stocks or stock mutual funds that day? By letting emotions control their investing decisions, they locked in their losses.
According to studies in the field of behavioral finance, various biases tend to drive our investment decisions. For example, many people succumb to "anchoring" bias. That's the irrational decision to hold on to something — a stock, a car, a piece of information — just because you already own it. Or you might fall prey to "recency" bias, the assumption that events in the recent past are a reliable predictor of the future. The stock market's been going up, up, up. So you jump on the bandwagon, assuming that the next twelve months will mirror the prior year. Don't count on it. When emotions rule the day, investment portfolios suffer.
To curb emotional investment decisions, consider the following two time-tested strategies:
  • Dollar-cost averaging. This is a strategy in which equal dollar amounts are invested at regular predetermined intervals. Percentage contributions from your biweekly paycheck to a 401(k) account are a good example of this type of investing. When the market's falling, you buy more shares in a stock mutual fund because the price of those shares is falling. Conversely, when the market's climbing, you enjoy the appreciation of your existing shares and buy fewer shares at premium prices.
  • Diversification. Because markets seldom move completely in unison, the strategy of investing in different industries, different countries, and different types of investments (stocks, bonds, and real estate, for example) can help reduce risk without substantially diminishing overall returns.
Above all, be honest with yourself. Sometimes a trusted advisor can provide an objective set of eyes to steer you away from poor investment decisions. You might also want to keep a journal to help you slow down, analyze your investment decisions, and allow your emotions time to cool off.
 
Anita T. Conner & Associates, P.C
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