How to avoid emotional investing

When the market started to tank in 2008, Edward Jones financial advisor Scott Gerlitz knew what was coming: clients would panic, want to ditch their investments, and run.

He managed to talk them down.

“We were fortunate in that in 2008, we did not have one client unload their portfolio,” says the Calgary-based Gerlitz. “It’s so critical to counsel people from taking that jump because trying to recover can be devastating.

“Emotional investing,” he adds, “is about making short-term choices that affect long-term circumstances adversely.

A recent survey from Bank of Montreal shows that at least two-thirds of Canadians are guilty of being guided by emotions, leading to impulsive investment decisions based on fear and anticipation.

Letting emotions take the wheel usually produces a detrimental effect. For proof of the downside of doing business when you let your feelings rule, look to the most recent Quantitative Analysis of Investor Behavior (QAIB) by DALBAR, a financial-industry research firm.

The analysis shows in 2011 the average equity fund investor underperformed the S&P 500 by 7.85 per cent. “The poor performance shows that psychological factors continue to harm the average investor and the remedies for these behaviors remain a work in progress,” the QAIB states.

The QAIB has consistently found that results are more dependent on investor behaviour than security performance. Mutual fund investors who hold on to their investments are more successful than those who try to time the market.

The QAIB points to “investor irrationality on display”. “One of the most startling and ongoing facts is that at no point in time have average investors remained invested for sufficiently long period to derive the benefits of the investments markets.”

Instead, people react to bad news and abandon investments at inopportune times.

“As markets have improved since 2009, we notice that it is easier for investors to make the right decision when markets are rising and their fear of loss is not the major decision driver," the report states.

So how can investors avoid acting irrationally every time the market dives?

Strategize
“A lot of times people don’t go into a strategy, so it’s more speculation or gambling,” Gerlitz says, noting that clients don’t like surprises. “If they expect that the road is going to be rough, they tend to stay with their plans — assuming you position plans properly and allocate portfolios according to their tolerance for risk and review and update that strategy every year.”

Buy quality investments
What type of investment vehicle you choose is just as important as the timing of purchase. “People always think about hitting the ball out of park instead of singles or doubles ... Don’t own anything now you’re not comfortable owing in a recession," Gerlitz says.

Diversify
“If you diversify investments by country, by industry, and by risk, you’re likely to have a greater chance of success, historically speaking,” Gerlitz says.

Understand risk
“Nothing is risk-free,” Gerlitz notes, adding even cash and GICs are subject to inflation and taxes. “Take whatever steps you can to mitigate risk. And if you make a mistake, address it very quickly.” Be sure your advisor fully understands you level of risk aversion in order to diminish the likelihood you'll abandon an investment when times get tough.

Focus on what you can control
“There are so many things that are beyond our control: legislation, interest rates, inflation, natural disasters, war, volatility … Those are all absolutely beyond our realm of control,” Gerlitz says. “However, there are many things you can control: how you allocate your asset, how well you diversify, how often you revisit portfolio, your spending, and your debt. If you can control those, you have a better chance of success."