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Reducing Investment Risk: How Your Emotions Can Increase Risk

Reducing Investment Risk: How Your Emotions Can Increase Risk

| March 13, 2018
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This is the part one in our Investment Risk Management series. A core part of our mission is to help our clients pursue their targeted returns with the least risk possible. This series will examine proactive strategies you can employ not only to reduce investment risk but also to pursue market opportunities.

What separates the investment performance of elite financial institutions from that of individual investors like you? Emotional investing.

Your emotions—both fear and greed—can significantly multiply your investment risk and affect your portfolio performance. How? Emotional investing can drive you to buy and sell at exactly the wrong times.

Buying at the Point of Maximum Investment Risk

Take a hypothetical average investor, Joe. Maybe like you, Joe will go through a cycle of emotions as he evaluates an investment opportunity, and this cycle will often lead him to buy at precisely the wrong time—the point of maximum market risk.

Stage One—Doubt: Joe hears of a hot stock tip from his work friend. He’s intrigued, but more doubtful and suspicious. The price is low, but he doesn’t buy.

Stage Two—Growing OpennessThe stock price moves up; his friend is making money. As this continues, Joe’s doubt morphs to caution and then teeters on confidence. He’s watching, considering.

How to reduce investing risk and stop emotional trading.

Stage Three—Purchase: The stock’s trading volume soars, mass excitement ensues, and its price-to-earnings ratio (P/E ratio) is incredible. His friend is beaming. Joe is excited. His eyes are wide with the possibility of a win. He feels little or no risk. He buys. The stock is now near or at its high. This is the point of maximum financial risk.

Selling at the Point of Maximum Financial Opportunity

Now that Joe has purchased his “hot” stock, he sits back to wait for the gains to roll in. But because he’s purchased at the top, his ride up quickly turns down.

Stage Four—Denial: Market forces take effect, and the price begins to fall. Initially, Joe is indifferent or in denial. He remains excited. His friend has made a killing.

Stage Five—Panic: The stock continues to fall, and Joe’s panic grows. Behavioral finance studies tell us what we all know instinctively: We hate to lose. In fact, we feel the pain of loss twice as intensely as we feel the rush of a win. Even though he’s panicking, Joe will now hold onto the darn thing—far too long—to avoid addressing the loss.

Stage Six—The Agony of Defeat (Sell): Utter despair and desperation kick in as Joe’s “hot stock” is at a low. He just wants to dump it. This is when most investors sell, despite that it’s the time of most significant loss. It's also the point of maximum financial opportunity.

Emotional Trading Can Increase Investment Losses

Investing based on emotions like Joe is one of the primary reasons the average investor realizes lower gains and sees more significant losses.

Dalbar, Inc., one of the nation’s leading financial services market-research firms, regularly studies investor behavior. In its 2016 Quantitative Analysis of Investor Behavior study, Dalbar reported that over the last 30 years, the average equity-fund investor underperformed the S&P 500 by 6.69%. They attributed the large gap to “voluntary investor behavior underperformance,” which according to the report includes panic selling, excessively exuberant buying, and attempts at market timing.

In our new normal of increased volatility, emotions have taken the driver’s seat for many investors, leading some to pull entirely out of the markets and into cash, even though they know logically they will incur monthly losses from inflation.

The fruit of this cycle can be seen in aggregate money flows in and out of the bonds and equities markets in recent peaks. As an example, below are dollar flows into the stock and bond markets in the years surrounding the early 2000s tech-stock crash.

Reduce stock market risk. Strategies for investment risk management.

The dot-com bubble started in 1995 and peaked in March 2000. The net inflow of funds into the stock market drastically jumped in the year of the peak. Investors were throwing money into the bubble at the time of highest financial risk.

How to Overcome Emotional Investing

The first step is to acknowledge you’ve been making emotionally based investment choices and stop. Next, move toward proactive decisions to buy at the point of maximum financial opportunity and sell at the point of maximum financial risk. In other words, buy low sell high.

We all know it, but our emotions get in the way.

Stop Listening to Greed and Fear

Greed can drive us to hold too long. Selling a stock when it’s still on the rise can be very difficult. The FOMO voice of greed says, “But what if there’s more?” Wisdom says, “It’s at its greatest risk.”

Fear can drive us to either buy too late or hold a losing investment way too long. Since we feel two times worse about losses than we feel good about gains, losing $10,000 feels twice as painful as winning $10,000 feels good. Instead of feeling the guaranteed pain of selling at a loss, we are likely to hold on longer than rationally makes sense in hopes that we won’t feel pain at all.

This suggests we’re more willing to take risks to avoid losses than take risks to achieve gains. This revelation can be paramount for some investors.

Stock market investing risk management

Stop Following the Herd

When a market is moving, we may fear others know more than us, and we tend to feel a strong pull to do what they do. This leads to choosing the latest “hot” stock or investing in the same asset class that was fruitful last year.

There is no historical evidence to suggest that people who follow the herd are better off; in fact, the crowd can be reliably wrong at critical junctures.

Our Investment Risk Management Strategy

Core to our investment strategy is the aim to help our clients pursue their targeted returns with the least risk possible.

One of the primary ways we do this is through a disciplined, forward-looking approach. Instead of investing in what did well last month, we’re analyzing each asset class’s current risk and future opportunities. We’re aiming to move away from risk and toward opportunities.

Here are a few strategies we employ to help reduce risk.

Reduce Investment Portfolio Volatility

The primary reason we use a tactical asset allocation investment strategy is to reduce portfolio volatility, and reducing volatility can help reduce market risk.

Institution-Level Planning & Tactical Investing

Some call it overkill for the average investor, but we call it stewardship. With each of our clients, we use the same tools as institution-level endowments, foundations, and pension funds: Personal Investment Policy Statements, individual Financial Plans, and a tactical asset allocation investment strategy.

Combined, these can help you work toward more stable returns, dampen volatility, and mitigate your investment risk.

In-House Analysis & Forecasting

An investment strategy is complicated, and those aiming to build and preserve their capital don't buy and hold, chase the latest hot tip, or invest because "it did well last year."

Our tactical approach is proactive, disciplined, and based on where we see the markets and economies heading. Our in-house team of analysts and portfolio managers regularly assesses the risk and return potential of each asset class to decrease risk in overvalued sectors and enhance returns in undervalued ones. This helps us follow the mantra: Buy low, sell high.

If you’d like to explore ways to reduce portfolio risk, let’s chat.

We’re pleased to offer a complimentary investment management consultation, either over the phone or in person. 

complimentary investment management consultation

Categories: Investing Risk, Investment Strategies

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. No strategy assures success or protects against loss. Stock investing involves risk, including loss of principal.

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