Protect your portfolio from your emotions
August 12, 2015
Humans are rational in theory but err in practice, according to cognitive scientists Philip Johnson-Laird and Ruth M. J. Byrne. But just because you're human doesn't mean you can't be a level-headed investor.
It's possible to catch yourself before making an emotion-based investment decision that could thwart your long-term objectives. The first step: Recognize how gut instinct can motivate you to act impulsively in the face of investment trends and market volatility.
The allure of what's trending
When people are faced with a lot of choices—for example, having a large selection of mutual funds to choose from—they're more likely to rely on popularity and consumer reviews to make a selection.
Hearing about a particular high-performing investment may make you want to buy it. Rationally, you know that past performance doesn't guarantee future results, but you don't want to miss out on an opportunity to increase your returns. And while investing in a top-performing fund may feel like the right thing to do, basing investment decisions on fund ratings alone isn't your best bet.
The urge to flee
Along the same lines, if you see your portfolio balance spike and dip during periods of market volatility, you may feel the urge to flee the market and abandon your asset allocation in favor of safer, lower-risk investments.
While this reactive behavior means you may miss out on the worst trading days, it also means you may miss out on the best ones. In many cases, timing the market for reentry simply results in selling low and buying high.
The benefit of being rational
You may not be able to control how you respond to market turbulence on an emotional level, but you can control how you respond to it on an intellectual one. The tips below can help you maintain perspective when making investment choices so you can keep your portfolio on track for the long run.
Start with a plan.
If you don't have one already, now's the time. Create a written financial plan or investment policy statement that includes:
- Your objectives.
- Your time frame.
- Your target asset mix.
- How often—and how much—you'll contribute to your portfolio.
- A budget that factors in current assets and debts, as well as any known future income sources and expenses.
- How often—and under what circumstances—you'll rebalance your portfolio or change your asset mix.
"In essence, a financial plan is a pinnacle of proactivity—it's a blueprint that's designed to give you the best chance for investing success," said Don Bennyhoff of Vanguard Investment Strategy Group. "Putting time and effort into your plan initially can benefit you in the long term—not to mention each time you're faced with what's trending or making headlines."
Think of your financial plan as an anchor.
Your financial plan is designed to help you reach your personal goals—not outperform the market at any given time.
"What's trending at the moment probably isn't what was trending when you created your plan," said Mr. Bennyhoff. "And what's in the headlines right now may make it feel difficult, at times, to stay the course—but keep in mind that although the headlines have changed, it's likely that your investment objectives haven't."
See the big picture.
Keep perspective. Focus on the progress of your entire portfolio over time, not on the ups and downs of individual investments.
This may be easier said than done, so prepare: Consider bookmarking a webpage (see some suggestions below) that you can refer to when you need a reminder to think long term. When you're looking directly at "evidence" of the potential rewards of staying the course—and the potential costs of market-timing and performance-chasing—you'll be less likely to make an impulsive decision.
- Maintain perspective and long-term discipline
- How to keep emotion from knocking your portfolio off balance
- Chasing fund performance may be hazardous to your wealth
"If you're on the brink of making a change to your portfolio, ask yourself what's driving the change," Mr. Bennyhoff said. "Is it driven by the market and what's in the headlines, or by a change in your own circumstances? We generally don't recommend changing your asset mix unless your own circumstances have changed."
Feeling panicky? Reach out to someone and talk about what you're feeling. If you have a financial advisor, start there (if you're considering partnering with an advisor, we can help). An advisor can act as an investing coach when you feel tempted to stray from your well-thought-out plan, providing valuable guidance. (Read our research paper to learn more.)
If you don't have a relationship with an advisor, you can talk with a Vanguard representative on the phone or connect with other investors on Vanguard social media. A like-minded friend or family member can also help you maintain perspective.
"Investing is hard. It's emotional. Investors have a lot at stake. Getting a more objective perspective from someone who's at arm's length from your portfolio can help you avoid making emotional decisions," said Mr. Bennyhoff.
- Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
- All investments are subject to risk, including possible loss of principal.
- Diversification does not ensure a profit or protect against a loss.
- Past performance is no guarantee of future results.