Investing can be an emotional process and successfully managing your emotions is one of the keys to realizing a positive long-term investment experience. In this episode, we dive into the emotional side of investing and share some thoughts and tips for how to win the emotional element of it. From understanding the purpose of investing and knowing what you’re investing for, to having the right perspective and expectations around investing, to focusing on what you can control and planning around what you cannot, there are several tangible things you can do to become a better investor. We dive into each, explain how to implement it, and share perspective on why it’s so important.
Outline of this episode
- For those who realize there's no shortcut in investing [1:12]
- Understanding the purpose of investing [1:59]
- Having perspective around investing [6:09]
- Managing emotions during market highs and lows [9:49]
- The recap [17:08]
What’s YOUR purpose for investing?
You're investing because you want to earn a better return on your money than keeping it in cash. But you also need to understand why you're investing within the context of your situation. Are you investing for retirement 30 plus years from now? Are you investing a small amount of money just for fun? Are you investing for college costs that will be coming 10 years down the road or maybe for a down payment you'll need in three years? Without knowing what you're investing for it leaves a gray area, and this is where mistakes occur.
If you're just investing to invest, who wouldn’t want to buy the next Apple or Amazon and have a hundred times return on your money! However, you can't have just one side of the coin. You have to also be aware of what happens if things don't play out the way you anticipated or hoped for. Risk and reward tend to be correlated, so if you invest in something with a higher potential return, the downside risk also has to be there.
Another step in better managing your emotions is having the proper perspective and expectations around investing. This is where you need to understand investment risk and reward and how they’re correlated. There are lots of ways to define risk, but we view it as a temporary fluctuation in the price of your investments over the near term. The more the price of an investment jumps around, the riskier the investment. For example, the bank account balance you have doesn't move on a daily basis, which is why there's no risk. Bonds move around in value a little bit more than cash, so the fluctuation adds some risk. Finally, stocks have even greater price movements than bonds, which makes them even riskier. The trade-off for the higher risk is the potential for a higher return. Unfortunately, you can't have one without the other.
Knowing the connection between risk and return can help you to have the proper expectation that your investments in stocks will move around a lot more than if you had bonds or cash. In fact, on average, the stock market experiences a peak to trough decline of almost 15% every year, a decline of 20% or more every 5 years or so, and a larger decline of 30% or more one out of every 10 years. However, if you zoom out on the time horizon to 5, 10, or 20 year periods, the percentage chance that your investments will be worth more in the future increase more and more.
Managing emotions during the ups and downs of investing
As we talked about, the stock market has historically gone up over time, but there's a lot of activity in both directions along the way. To keep things simple, we'll break down the stock market experiences into two main categories, investing during a market decline and investing during a period where the market is going up. The framework is the same for both of them, which is to focus on what you can control and ignore what you can't. There are several tangible things you can do depending on what's happening in the stock market at a particular time that can potentially help you better manage the emotions of investing.
One thing that you can do to take advantage of both market declines and increases is to rebalance your portfolio. If the stock market is down, this is an opportunity to buy stocks at cheaper prices. This is one of the best opportunities to buy more at a lower price, knowing the future price will likely be higher. When your investments are performing well, you can sell whatever has outperformed and buy more of whatever has underperformed. This allows you to complete the cycle of buying low (rebalancing during a stock market decline) and selling high (rebalancing after a strong period of market performance) but without trying to time things or make any guesses. Rebalancing also allows you to keep your investment allocation on target with what's required to meet your goals and to avoid any large drifts from your desired allocation.
Resources & People Mentioned
- Download our guide: The Toolkit for Optimizing Your Finances as an Employed Physician
- Podcast Episode #5: The 80:20 Rule of Investing
- Podcast Episode #19: The “Other 20%” of Successful Investing