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“Until you can manage your emotions, don’t expect to manage money.” – Warren Buffett

profit and loss illustration

One of the main assumptions in basic economic theory is that we all make rational decisions. Unfortunately economic theory doesn’t always translate so well into the real world. Have you ever made an irrational decision and let your emotions get the best of you? Of course you have. We all have done this at some point in our lifetime.

The reason you see so many wild swings up and down in the stock market has absolutely nothing to do with company earnings or economic growth. It has everything to do with human nature and our cognitive biases which force us into making the wrong decisions at the worst times.

What happens when we let our emotions control our investment decisions

According to Vanguard founder John Bogle, the average equity mutual fund gained 173% from 1997 to 2011. That’s not a bad rate of return at just below 7.5% per year. But the average equity mutual fund investor did not actually get to enjoy those returns. They only earned 110% (or about 5.4% per year) over that time frame, thanks to the tendency to buy high and sell low. The reason for this difference is that we let our emotions control our investment decisions and actions.

Fear and greed are your biggest enemies when implementing an investment strategy. Unfortunately our cognitive biases work to amplify these two emotions right when we need to contain them the most. Studies have shown that we are twice as depressed from losing money as we are pleased from gaining money. This can lead to fear taking over our decisions.

Buy low, sell high

We have all heard the phrase buy low, sell high to make money investing over time. This is easier said than done in most cases. When we see stocks go down in price we get nervous that the declines are going to continue indefinitely. This is our tendency to have a recency bias causing investors to extrapolate the recent past into their future predictions. So many investors were focused on the market crash of 2007-2008 that they couldn’t possibly imagine that stocks would rally over the ensuing 4 years. We tell ourselves we will just sit it out until things get better. Because of these biases we sell when stocks are down. So we sell low instead of following our common sense advice of buying low.

On the other end of the spectrum is the problem of overconfidence. Overconfidence leads many of us to think we know how the future will play out and that we make all of the right moves. This can lead to greed. This situation played itself out in the late-1990’s technology bubble. Investors simply assumed that the market would continue to rise forever and failed to take into account the historical viewpoint that markets can overheat and become overvalued. And once gains start to accumulate we get the feeling that we are playing with house money so we continue to increase risk and buy more. We feel that we will miss out on the action if we don’t get in right now.

The confirmation bias causes us to only seek out only the information that supports our current viewpoint. When things are going well we don’t want to be bothered with the fact that there are alternate points of view. We just want to continue making money because we are such great investors when stocks are rising. Greed, overconfidence and the confirmation bias all cause us to buy high instead of buying low as we should.

Herd mentality

We also tend to follow the herd when making decisions. It’s much easier to fail when everyone else around you is in the same position. But to be successful investors and implement the buy low, sell high philosophy you actually have to go against the grain and be a contrarian. As famed investor and billionaire Howard Marks recently stated, “When others love investments, we should be cautious. But when others hate them, we should turn aggressive.”

Now, let me be clear, this is not an easy thing to do. No one wants to lock in gains and sell when markets are rising and good times are all around us. And it’s very difficult to force yourself to buy when markets are declining because the collective mood is so negative.

Realize that you cannot control the future

One of the biggest reasons that we let fear and greed control our decisions is that there are an abundance of unknowns that we just cannot predict. You have to be willing to admit to yourself that you don’t know what’s going to happen in the future. There will always be the element of the unknown. You have no control over the economy, the stock market, politics or what everyone else does with their money. Coming to grips with this reality will save you a lot of stress and sleepless nights worrying about your finances.

So, if you are willing to admit you don’t know what is going to happen in the future and that humans make irrational decisions from time to time how do you control behavior to save and invest for retirement?

Come up with an investment strategy

The first thing you need to do is come up with a comprehensive goals-based plan. For this to work you need to know why you are saving and investing. Circumstances will change and so too will your goals but you must set objectives to be able to benchmark yourself along the way to make sure you are on the right track. Studies have shown that measurement actually improves performance over time so figure out simple ways to track your progress.

The amount of choices can be overwhelming when you first start to invest. So focus on those areas that will have the biggest impact on the long-term. The first decision you need to make deals with your asset allocation (how you split your funds between stocks, bonds, cash and other investments). Studies have shown that this can explain up to 90% of the variation in your investment performance so this decision is much more important than the individual stocks, mutual fund or ETFs you invest in.

Determine your asset allocation

Set your asset allocation based on your risk profile and time horizon. You need to take into account your age, net worth, salary and amount of time until you actually need the money. These factors determine your ability to take risk. But you also must determine your willingness to take risk. Make sure you are comfortable with the amount of money you put in risky assets otherwise your behavioral biases will force you to make short-term decisions that will hurt you in the long-term. Younger investors should be able to have a higher percentage of their asset in stocks than those closer to retirement since they have a longer time frame to make up losses.

Automate your investment strategy

Once your asset allocation is set you can work on automating your rational decisions. That means setting up your accounts to save on a periodic basis so you dollar cost average into the market. You can also automatically set your accounts to be re-balanced back to your target asset allocation weights. This will force you to periodically buy low and sell high, the opposite of our irrational choices.

Re-balance periodically

Since you will have some investments that perform better than others their weights will increase and cause your portfolio to come out of balance. Setting up a periodic re-balance (quarterly or semi-annually should do it) forces you to sell your winners and buys your laggards. If you choose a simple allocation of 75% stocks and 25% bonds and stocks rise to 80% of your portfolio because of large gains, you will know what to do. Sell some stocks and buy some bonds to get back to your target weights. It won’t feel like the right thing to do, but that’s the point of controlling our biases that force us into bad decisions.

Learning how to pinpoint our irrational behaviors and learn from them can be a healthy exercise. It will give you the correct long-term perspective you need to become a successful investor. More importantly it will help you achieve your financial and personal goals.

Ben Carlson writes about personal finance, investments and investor psychology at A Wealth of Common Sense.