In my humble opinion, emotional investing causes more people to lose money in the stock market than any other reason. Buy low and sell high.” That’s how to make money in the stock market, right? Unfortunately, when you let emotions get the better of you the decisions you make tend to be the exact opposite.
When you make financial decisions based on emotions they’re almost always the worst decision you can make. There’s no difference whether those emotions are a thrilling high or a depressing low. In either case, you end up making the wrong decision, which results in you losing money.
Warren Buffet, arguably the most well-known investor of our time, has said, “You only have to do a very few things right in your life so long as you don’t do too many things wrong.” You don’t have to be a brilliant investor, you simply must avoid making the big mistakes. If you follow your emotions when it comes to investing you will make big mistakes.
What Causes Emotions?
The stock market goes up and down. It fluctuates every minute, hour, day, week and year while the market is open for trading. The larger the fluctuations, the more emotions they generate. When the market goes up a small amount, say a half a percent, it’s no big deal. You smile a bit and go on about your business. BUT, if the market goes up a LOT the emotions kick in. A rise in the market may just be for a day, but it also may be over several years! The more the market goes up, the more excited you get. Big gains equal big emotions. Pride, joy, happiness, and euphoria well up in you. I know. I’ve been there.
Then, the market goes down. Once again, the bigger the drop the bigger your emotions. There’s nothing quite like having your $500,000 portfolio go down by 10% in a week or two resulting in a loss of $50,000 in value! Once again, the loss may be a quick 2-week correction, or it may be a full-on bear market where the market drops 20% or more over several months. When you have big losses you feel depressed, defeated, angry, or despondent. I know. I’ve been there too.
Why Does the Market Fluctuate?
When we refer to the market, we mean the composite prices of stocks that comprise one of the indexes. There are three main indexes that we associate with the US stock market: the Standard and Poors 500 (S&P 500), the National Association of Securities Dealers Automated Quotations (Nasdaq), and the Dow Jones Industrial Average. There are others, but these are the big three. You can ask 20 financial analysts why the market fluctuates and you may get 20 different answers. But in truth, it all boils down to Supply and Demand.
A Mini-economics Lesson – Supply and Demand
To learn about the law of supply and demand we’ll look at a fictitious case study. You own shares of stock in the ABC Gadget Company (stock symbol: ABCG) that are currently valued at $10 a share. In our perfect little world, all the people who want ABCG stock that is valued at $10 a share have all the shares they want.
When Demand is Higher than Supply Prices Go Up
The CEO of ABC Gadget announces the company has perfected new technology that will produce twice as many gadgets at half the cost. As a shareholder and thus part owner of this company, this is great news for you! It seems certain that ABCG is going to be much more profitable than before. As quickly as the announcement is made buyers start purchasing shares of the company. The problem is that there’s a finite number of shares and the people who own them have no doubt heard the news as well. They’re not tempted to sell their shares for only $10 each.
In this scenario, there’s a higher demand for shares of stock than there is a supply of shares owned by willing sellers. This causes buyers to bid more for each share of stock driving the price up. As the price goes up a few owners of the stock are willing to sell, but not enough to satisfy the demand. Buyers continue to raise their offered price for the shares of stock and more seller are persuaded to sell.
As the price goes up, buyers begin to satisfy their demand for the stock. Also, some buyers don’t want to pay the new higher price for the stock, so demand decreases. At the same time, the sellers of the stock have fewer shares to sell. Those who were inclined to sell have done so. At some point (again in our perfect world) the demand and the supply reach a balance or equilibrium and the price stops rising.
When Demand is Lower than the Supply Prices Go Down
The flip side of the coin is if the CEO announced that ABC Gadget had missed their sales projections. The company had a loss for the first quarter in their history and that’s forcing them to reduce staffing and production.
Now people who own the stock assume that it’s not going to be as profitable as they thought. They try to sell their shares of stock. But, potential buyers aren’t willing to pay $10 a share any longer. The sellers must offer their shares at a discount to attract buyers. Since the supply is greater than demand the price is driven down. As the price is driven lower the demand for the lower priced stock is satisfied and fewer people are interested in selling their shares until an equilibrium is met again.
The Market Is Fickle
The market can and will rise or fall for any reason–or no reason at all. Financial pundits on the TV will try to explain movements in the market. But many times their reasons are simply guesses. A large shareholder may decide to sell a lot of shares of stock to raise money for something personal. This causes an influx of extra shares into the market, which increases supply causing the price to drop. As the price drops other shareholders may get nervous (emotions) and decide to sell some or all of their shares driving the price down further.
There’s no accurate way to predict what the market will do. When a company announces they have record earnings you might expect the price of their stock to go up. But it might not. The market may already have priced in the fact that the company was going to have record earnings. Their good news may not be as good as some investors had hoped.
In 1995 and 1996 the S&P 500 was up over 53%! You might think that the market was due to slow down or even retreat. If you had sold your stocks at the end of 1996 you would have missed additional gains of over 77% over the next three years! The point of all this is that there’s no accurate way to predict when the market will go up and when it will go down over shorter periods of time.
Where Emotions Come In
There’s an adage concerning the stock market—to make money you buy low and sell high. Unfortunately, emotions tell you to do the exact opposite!
You may begin to be concerned when your investments start going down. The more they go down, that concern may turn into full-blown panic. Notice that I said “when” your investment start going down, not “if.” Over the long haul, we’re counting on our investments to increase. But, over the 30-40 years that you’ll need to grow your wealth, the market will have some significant down times. Expect it.
When these times happen it’s normal to get scared that you’re going to lose all your money. Relax. If you’re invested in a fund that holds shares of dozens of companies each one of those companies would have to go out of business for you to lose all your money. But, your emotions tell you something different. They tell you to sell all the shares you own before you lose it all. You panic. And in doing so you do the opposite of what you should be doing—you sell when prices are low.
Just as dangerous is when your investments are going up. As the value of your investments increases, you feel satisfied, then confident, and finally euphoric. During these times it’s easy to believe that you’ve got this investment stuff all figured out and you can’t go wrong. You get over-confident about your investing prowess. You may read an article about a certain investment that has done great and you want to get in on the party. The problem is that by the time you hear about it, the party is winding down.
When you’re afraid you might miss the next big growth opportunity, you probably already have. By chasing the best performers you’re buying after they have increased in value and when they’re near their all-time high. Again, you’re doing the exact opposite of what you should be doing—you’re buying high. In these ways, emotions cause you to buy high and sell low. This is a sure-fire way to lose money in your investments.
Check Your Emotions at the Door
To avoid making these emotional mistakes, check your emotions at the door. The best way of doing this is to have a strategy like the one described in this blog. Follow that strategy regardless of whether the market is going up or down. The strategy I recommend is to buy and hold shares of index funds. While past performance is no guarantee of future returns, the market has always bounced back from losses and returned solid gains in the long run.
Your Quick Start to Financial Independence
Given enough time you’ll likely be able to ride out any downturn in the market. As soon as you panic and start to sell you’ll be locking in those losses. Don’t let your emotions get the best of you. Have a plan and stick to it.
Why is This Important to You?
Knowing how emotions affect your investments will help you understand that the ups and downs in the market are normal and can be expected. You’ll get excited or worried, but as long as you don’t act on those emotions you should be OK. Emotional investing is a guaranteed way to lose money and can be a detriment to your wealth building. Recognize what’s happening and stick to your plan.
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