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How to keep emotions in check

May 22, 2013

It's easy to get caught up in Wall Street's mood swings.

That's especially true when you've got self-appointed experts practically screaming at you to buy this or sell that—and to do so NOW, lest another moment slip by.

But the fact is, investment decisions based on emotional reactions rarely end well. By the time you've jumped on (or off) an investment bandwagon, chances are you've already missed out on whatever advantage you might have gained. Instead of trying to time the market, look at the big picture and think long-term.

INTERACTIVE TOOL

See how emotion can sabotage your strategy

Use our interactive illustration to see how pulling out of the market after a downturn and then getting back in after a rebound has generally been a losing strategy.

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It's not always easy, but having a plan—and the discipline to stick to it—is one of the best ways to reach your financial goals.

Tune out the noise

One safe prediction about the financial markets is that they're completely unpredictable. That's why market-timing and performance-chasing seldom work.

Consider the interactive illustration on this page, which shows how pulling out of the stock market after a downturn and then getting back in after a rebound has generally been a losing strategy. While it's possible to create scenarios in which you outperform the market, you'd have to possess remarkable foresight to make such an approach work in real life. And it's worth noting that the illustration doesn't account for investment costs, which act as a drag on performance. So, even if you did manage to beat the market, your expenses might well erase your gains.

Granted, it's hard to ignore market turbulence and the storm of "expert" advice it generates—especially when your portfolio is suffering. The best way to build wealth over the long run is to follow a disciplined long-term investing strategy with an appropriate asset allocation for your time frame, objectives, and risk tolerance.

Ignoring the hype and hysteria lets you focus on the things that really count.

Create a road map

Imagine setting off on a long journey without a map. Pretty foolish, right? That's essentially what many people do with their money every day.

Fortunately, creating a plan is simply a matter of setting targets, understanding the options and risks, and establishing a regular investment schedule—preferably using an automated approach, such as payroll deductions into a 401(k) account or regular deposits into an IRA.

Your investment plan can be as detailed or as general as your circumstances require. If your financial situation is complex, you may want to consult a professional planner. Websites abound with interactive worksheets and calculators suitable for most investors.

Don't wait for the next swing in the bull/bear cycle to get started. A solid investment plan, factoring in your asset allocation targets and risk tolerance, can help you through the market's inevitable stormy patches. Otherwise, you might end up making spur-of-the-moment decisions based on emotional hunches and gut reactions.

Many investors think they can anticipate what the markets will do next. History shows that they're usually wrong.

Stay on course

Your investment plan is only as good as your willingness to follow it. Still, sometimes adjustments are necessary. Checking your asset allocation once a year is a good rule of thumb.

If, over the past year, you've moved away from your asset allocation target by more than 5% or so, you may want to consider rebalancing your portfolio—unless you've decided that it's time to update your investment plan and the new allocation is more appropriate to your strategy.

There are several ways to stay on course by adjusting your asset allocation:

  • Periodically adjust your asset mix by selling shares of your "overweighted" asset class and buying more shares of your "underweighted" class. (Be aware of potential capital gains implications any time you sell shares.)
  • Gradually boost your underweighted class with new contributions or by supplementing it with your dividends and capital gains.
  • Consider investing in a mutual fund that automatically adjusts its underlying asset mix as the target date approaches.

Avoid these pitfalls

No journey is without danger, and when you're investing, there's always the risk that you'll lose money. But you stand a better chance of staying on track by keeping emotion in check and avoiding some common mistakes:

  • Market-timing. You can't predict the market, so resist the urge to make major changes to your portfolio on a whim.
  • Chasing performance. Basing your investment decisions on what the market did yesterday is like trying to drive by looking only in your rearview mirror. Past performance can tell you some useful things, but it's no guarantee of future results.
  • Miscalculating risk. Everyone has a certain comfort level when it comes to investment risk. Know your risk tolerance and allocate your assets accordingly.
  • Overweighting. Are all of your eggs in one basket? It can be tempting to load up on one particular type of investment, especially when that investment is doing well. But in doing so, you could be inviting misfortune.
  • Overlapping investments. You can mitigate risk by owning several different mutual funds. But funds with widely different objectives can have overlapping holdings. You might be surprised to find that you've invested in the same company several times.

NOTES:

  • All investing is subject to risk, including possible loss of principal.
  • Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund's name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a target-date fund is not guaranteed at any time, including on or after the target date.
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