Unfortunately, emotional risk is one of the toughest risks to overcome and it can be devastating to investors’ long-term investment returns. When investors succumb to emotions and feelings of fear/panic after their investment values decline in value or happiness and euphoria after an investment value rises, rational decision making often goes out the window. Let’s go through your emotions.
Emotional Cycle of an Emotional Investor
Investments Going Up
Investors are often happiest when their investment values are going up and/or income generating assets provide income. Anyone would feel happy when their wealth is increasing. As their investments continue to move higher, and higher and higher, the emotional investor will feel more comfortable with the markets and want to continue to add more risk to their investments. As emotional investors around the world continue to become excited, they continue to add more to their investments, pushing their investments even higher.
Investments Stagnating
When an emotional investors investments are stagnating or not going up as much, they will often ignore their investments so as to not think about their investments as they are not as exciting anymore. They will believe that even if their investments haven’t gone up as much as they once did, they are “in the money” and are “ok” if the market sells off a bit. They will reiterate to themselves they are long-term investors and will hold on “no matter what”.
Investments Falling
The emotional investor will see their investments modestly declining in value, but they are ok with it as they remind themselves they are still in the money and will “ride out the volatility”. They continue to believe they are long-term investors, but some uncertainty creeps in whether or not they should reduce some risk in their portfolio. The emotional investor that starts to get nervous will “wait until the market bounces” to reduce exposure to their investments.
Investments Falling Faster
The emotional investor starts to get nervous. They start to believe that maybe what they thought was a great long-term investment was a potential mistake and maybe their initial thesis was incorrect. Their previous profits have declined and/or may start to become not profitable at all. The emotional investor may start to get nervous and will start to reduce their exposure to their investments because they see the valuations going down. The emotional investor is less interested in the long-term fundamentals of their investment, but rather the price of their investments going down.
Investments Fall off the Cliff
The emotional investor can no longer take the pain and believes that their thesis is completely incorrect or that the “market is rigged” for the average person and that hedge funds are to blame. The emotional investor has no care about the long-term fundamentals of the investment but just needs to get out and sells out of their entire position to go to cash and “wait it out”.
Market Rebounds
After the emotional investor and other emotional investors around the world sell their investments, the market rebounds quickly higher. The emotional investor believes that this is a false rally or a “dead cat bounce” and is highly confident that the market will turn back around lower.
Market Continues to Move Higher
The emotional investor can’t believe that the market continues to move higher and believes that maybe this is an actual sustainable move higher. The emotional investor remembers their original thesis of the investment and vows to stick with it after the market rebounds substantially after the emotional investor sold their position.
Market Corrects after Rallying
The emotional investor that just got back into their investment after the market rallied, is now experiencing another selloff in the readded position. The position continues to decline and value and the emotional investor gets nervous that maybe they were correct during the first selloff and gets out of the position again.
Market Rebounds after the Correction
The emotional investor can’t believe that the investment rallied again after they sold it again and the emotional investor gives up and finds another investment opportunity to consider.
New Investment That Has Rallied
The emotional investor, trying to find a “can’t lose” investment, finds another investment that has done really well the last couple of years. The emotional investor wants in on the action and puts money in this new exciting investment that has performed very well. The emotional investor didn’t do so well on their other investment, so they double down on this new investment to try to make up ground they lost in the previous investment.
The New Investment Stagnates
The emotional investor’s new investment stagnates after the emotional investor just bought it. The emotional investor holds on, vowing to be a long-term investor this time around. Aaaannddd the cycle continues…
The Rational Investor
Like emotional investors, rational investors are happy when their wealth increases. Who wouldn’t? The difference of a rational investor is that rational investors tend to have a plan prior to their investments do something. A rational investor may become increasingly skeptical of the rise of their investments above or below their estimate of rationality, maybe based on fundamentals or technical signals. The rational investor will often have a plan before their investment values change, due to some sort of market environment. Then when the investment value reaches a certain level (higher or lower), the rational investor will execute their plan they had in place.
| Investment | Emotional Investor | Rational Investor |
| Investment Purchased | Sees an investment that has done well. Makes first purchase. | Investor performs deep due diligence and is comfortable with the long-term prospects of the investment. |
| Investment Rallies | Loves that they got an investment correct and adds a little bit more. | Maintains current position and if it rallies more than anticipated, sells a bit and rebalances their portfolio. |
| Investment Rallies More | Believes this is a great investment and has done better than other investments, so adds more to the position. | The investment price no longer makes sense based on the fundamentals and significantly reduces or sells out of the position for profit. |
| Investment Stagnates | Ignoring for now as it is not as exciting anymore. They will believe that even if their investments haven’t gone up as much as they once did, they are “in the money” and are “ok” if the market sells off a bit. They will reiterate to themselves they are long-term investors and will hold on “no matter what”. | Long-term rational investor anticipated a period of consolidation and holds on as fundamentals catch up to the price. |
| Investment Declines | The emotional investor will see their investments modestly declining in value, but they are ok with it as they remind themselves they are still in the money and will “ride out the volatility”. They continue to believe they are long-term investors, but some uncertainty creeps in whether or not they should reduce some risk in their portfolio. The emotional investor that starts to get nervous will “wait until the market bounces” to reduce exposure to their investments. | Believes current valuations didn’t make sense and are glad they had reduced exposure and/or sold the position. May consider adding back as valuations are more attractive. |
| Investment Declines Faster | The emotional investor starts to get nervous. They start to believe that maybe what they thought was a great long-term investment was a potential mistake and maybe their initial thesis was incorrect. Their previous profits have declined and/or may start to become not profitable at all. The emotional investor may start to get nervous and will start to reduce their exposure to their investments because they see the valuations going down. The emotional investor is less interested in the long-term fundamentals of their investment, but rather the price of their investments going down. | Methodically adds to the position as valuations are becoming more attractive relative to the long-term fundamental prospects. |
| Investment Crashes | The emotional investor can no longer take the pain and believes that their thesis is completely incorrect or that the “market is rigged” for the average person and that hedge funds are to blame. The emotional investor has no care about the long-term fundamentals of the investment but just needs to get out and sells out of their entire position to go to cash and “wait it out”. | Takes a full position in the investment again as valuations are cheap and the long-term fundamentals have not changed. |
| Investment Rebounds | After the emotional investor and other emotional investors around the world sell their investments, the market rebounds quickly higher. The emotional investor believes that this is a false rally or a “dead cat bounce” and is highly confident that the market will turn back around lower. | Holds on to current position until valuations become unattractive. |
| Investment Keeps Rebounding | The emotional investor can’t believe that the market continues to move higher and believes that maybe this is an actual sustainable move higher. The emotional investor remembers their original thesis of the investment and vows to stick with it after the market rebounds substantially after the emotional investor sold their position. | Holds on to current position until valuations become unattractive. |
| Investment Corrects | The emotional investor that just got back into their investment after the market rallied, is now experiencing another selloff in the readded position. The position continues to decline and value and the emotional investor gets nervous that maybe they were correct during the first selloff and gets out of the position again. | Holds on to current position until valuations become unattractive. |
| Investment Moves Higher | The emotional investor can’t believe that the investment rallied again after they sold it again and the emotional investor gives up and finds another investment opportunity to consider. | Valuations become less attractive from where they added positions and starts to reduce position. |
| New Investment | The emotional investor, trying to find a “can’t lose” investment, finds another investment that has done really well the last couple of years. The emotional investor wants in on the action and puts money in this new exciting investment that has performed very well. The emotional investor didn’t do so well on their other investment, so they double down on this new investment to try to make up ground they lost in the previous investment. | Maintains a diversified portfolio of investments. |
| New Investment Stagnates | The emotional investor’s new investment stagnates after the emotional investor just bought it. The emotional investor holds on, vowing to be a long-term investor this time around. Aaaannddd the cycle continues… | Maintains a diversified portfolio of investments. |
| Summary | The emotional ivnestor often buys after an investment rallies and sells after the investment declines significantly, effectively buying high and selling low. | The rational fundamental investor often does research and determines a price that is worth investing and a price that is not, effectively buying low and selling high. |
No One Knows What The Market Will Do At Any Time
I have been in this business working closely with institutional money managers from firms that manage in the trillions of dollars and financial advisors with plenty of experience. I’ve learned that no one knows what the market will do at any given time, regardless of what they say. I have heard investment portfolio managers from firms that manage trillions of dollars, where one portfolio manager says and believes one thing, and another portfolio manager from the same firm with the same data, believes something else. If two portfolio managers at a firm that manages trillions of dollars, with the same investment team, analysts, and technology available to them can come up with different conclusions on where the market is going, then it’s hard to believe that anyone knows what the market will do at any time.
If experienced money managers (including myself) cannot know exactly what the market will do at any time, then you should not have any confidence that you will know what the market will do at any time. For this reason, to at least try to avoid the negative results of emotional investing, have a pre-set plan of what you will do when the market does something.
While no one knows exactly what the market will do at any time, or knows when a market top or bottom will be, there are tendencies of a market that has higher probability of occurring based on historical fundamental and technical data. While this can help people make informed decisions, the probabilities are never 100%. These probabilities can shift quickly, depending on the market environment. A 55% probability of a market event happening is better than a 50/50 bet, but even that 55% has the potential to be 45% wrong. Many professional investors utilize some sort of probabilities to make investment decisions which is better than nothing, but you should know, that nothing is guaranteed and these probabilities can change, regardless of how high the initial probabilities of something occurring are.
Do Not Be an Emotional Investor