The importance of removing emotion from your investment portfolio
The phrase “we are only human” is a cliché that speaks volumes about the ability – or lack thereof – to overcome our inherent biological and psychological limitations and resist deeply ingrained social behaviors to make better, more informed decisions. There is nothing more intrinsically human than emotion – and yet, at the same time, there is nothing more counterproductive to successfully planning, establishing and maintaining a sound investment portfolio. Doing the smart thing can sometimes feel wrong, and making financial decisions based on anything other than unbiased critical thinking and careful analysis is a risky proposition.
Resisting the powerful tug of emotional influence is particularly difficult for individuals in financial planning, because virtually everything about smart investing flies in the face of our instinctive emotional framework. Smart investing is objective instead of subjective; involves data-based decision-making instead of going with gut instinct; and places an emphasis on long-term strategic planning instead of the more immediate satisfaction of short-term gains.
But the question is: How do you separate what you want to do from what you should do? Financial advisors have long understood that finding an answer to that question is consistently their biggest challenge in terms of helping clients structure their assets, adhere faithfully to a long-term strategy, and ultimately realize a reasonable rate of return on their investments. Answering that question is especially relevant today in light of the ongoing turbulence and uncertainty in the market. Even the most experienced investors and savvy professionals might find it helpful to review some basic ground rules and helpful reminders of how to invest with the head, instead of the heart.
Resolving the conflict between emotion and critical thinking and successfully applying a long-term strategic perspective to investment decisions involves several important elements. Those fundamental guidelines include the following core ideas:
Some of the most important investment decisions are made before a single dollar is allocated. Generally speaking, there are three fundamental prerequisites to investing that every prospective investor should strive for. Following these pre-investment guidelines greatly increases the odds that the investment process will be a positive and productive experience:
- Achieve a positive cash flow. You can’t invest what you don’t have, and any decisions made with money that may or may not be needed to address more immediate priorities can motivate you to compromise your investment principles in the name of short-term relief.
- Eliminate debt. Debt compounds upon itself, digging a hole that seems impossible to close. Until that debt is paid off, investing additional monies doesn’t make sense.
- Establish an emergency fund. Establishing an emergency fund before investing ensures that investment decisions are always made with long-term goals and priorities in mind. This is a point that may be particularly resonant during tough economic times. If someone gets laid off or faces unexpected financial hardship, it is important that they have enough financial flexibility built-in to the their overall strategy that they can move forward without touching their investments or making decisions based on panic.
Generally speaking, the best way to approach investing and financial planning is to prepare ahead of time and approach the process thoughtfully and strategically. Take an inventory of where you are in your life, and where you want to be five, ten or twenty years down the road. Take on risk that is appropriate to where you and your family are financially, and that fits your needs, age bracket, and so on. The goal should be to determine what this money means to you, and to structure your portfolio accordingly. Is it a 20-year investment horizon you are working with, or is it a quicker turnaround? What are you investing for? Investments made with a shorter timeline are more susceptible to short-term market swings, and investors are generally more emotionally tied to the money and apt to make reactive decisions.
- Lose nostalgia. It may be easy to invest based upon companies that have meaning to you or your family, but one of the easiest ways to lose sound investment strategy to emotion is choosing investments based upon fond feelings.
- Don’t let fear drive investments. Fear is a powerful tool in many situations, but cripples investment portfolios. The general trend when the market goes down is to pull the remaining money out, but history shows that investors that continue the course regardless of the ups and downs of the market will fare better in the end.
- Envy is not a strategy. Don’t invest money to try to play catch up with neighbors or friends. Setting a bar based upon returns from those around you makes for poor investment decisions that can derail long-term goals.
- Unplug. Turn off the TV. Or at least be willing and able to take the hype with a grain of salt. The hyper-realism of today’s 24-hour news abetted by cell phones, instant messages, scrolling news headlines and the ever-present stock-ticker can be overwhelming, and sometimes hard to ignore. Savvy investors will stay informed, but will not let short-term dynamics influence them. Responding to volatility in the markets or the daily headlines by buying or selling in contradiction to your own investment strategies is one of the worst things you can do. Slow and steady may be an investment cliché, but it is a cliché for a reason: it works.
Once you settle an overall strategy and decide what your goals and guidelines will be for individual investments, put it in writing! Many institutions are required to produce an Investment Policy Statement, and it is a good idea for individuals to get into the habit of doing the same thing. Part of this process should involve developing a strategic plan for buying and selling; a list of conditions and written guidelines that will help ensure that you don’t respond impulsively to short-term swings in the market; but instead do what works for you and is in keeping with long-range goals.
One of the fundamental errors that so many inexperienced investors make is confusing rate of return with the overall level of risk. Ignore risk at your peril! A strong rate of return is not everything, and if something is twice as risky, it might not be the right move for a particular investor. Frequently, a long-term investment with a more modest rate of return makes much more sense than a seemingly more attractive short-term scenario with a higher degree of risk.
Work with a pro
It is always important to speak with and get advice and guidance from a trusted professional. Some professionals are so aware of the degree to which emotion can influence the decision-making of their clients that they make a point to try and avoid meeting with clients on particularly bad or good news days. They want to discuss these things in a vacuum, and they understand the importance of removing emotion from the equation as much as possible.
Take the plunge
Following these steps will help ensure that when you do invest, you will be able to parlay your planning, foresight and thoughtful self-assessment into investments that meet your needs and present an appropriate amount of risk for your specific circumstances. This is where professional guidance can come in particularly handy, as an experienced investment advisor will be best able to help structure a portfolio that translates your priorities into an appropriate allocation.
In the final analysis, it is quite revealing that the entire premise behind the age-old investment wisdom of buying low and selling high is predicated on an approach to investing that ignores emotion. The counterintuitive nature of the business and the “if it feels right it is probably wrong” characterization of so many aspects of financial planning simply reinforce the importance of emotion-free decision-making. Ultimately, the ability to get out of your own way and make sound, thoughtful and strategic investment decisions will lead to a more prosperous and secure financial future.
About the Author:
Jonathan Citrin founded CitrinGroup in 2003 and serves at its Chief Executive Officer, Chief Compliance Officer and Chairman of its Investment Policy Board. As such, Citrin is responsible for overseeing the day-to-day operations of CitrinGroup and maintaining a stringent, unbiased investment process for the firm’s clients.
Prior to starting CitrinGroup, Citrin occupied the position of Financial Advisor at Morgan Stanley and Morgan Stanley Dean Witter. Citrin is an Adjunct Professor of Finance at Wayne State University's School of Business Administration, where his classes include Security Analysis and Business Finance.
In addition to his professional work, Citrin devotes time to several philanthropic endeavors. He is on the Board of Directors of Starfish Family Services, a Michigan-based non-profit organization. He is also a board member of the Jewish Community Centers of Detroit and devotes time to the Jewish Federation of Metro Detroit where he is a member of the Grants & Distributions Committee, Missions Committee and Government Relations Oversight Committee.
Citrin received his B.A. from Tulane University and his M.A. from New York University.
For more information, please visit www.citringroup.com.