Our flight-or-fight responses may be a primitive psychological trait we’ve inherited from our caveman ancestors, but that doesn’t mean we need to heed those emotions when we invest. It is important to stay rational when investing in the marketplace and exchange traded funds (ETFs), otherwise we will be subject to the errors our emotions bring forth.
According to David Allison for Investopedia, there are some specific phrases to look out for, especially since they may signal mental errors and biases in a bull market.
- “I know investment markets are going to pull back. I will put the money to work then.” This phrase could cause a “confirmation bias.” Confirmation bias results when the human brain tries to avoid two conflicting thoughts. Investors try and filter out the evidence that contradicts their own beliefs, sticking to what they want to hear. During a new bull, this bias could cause investors to completely glance over signs of recovery and miss their chance at a distending market. [Mistakes ETF Investors Make.]
- “I finally had a profit, so I sold that investment.” Investors fear the pain that results from investment loss hurting much worse than the pleasure of gains, or otherwise known as “disposition effect.” In a new bull market, this type of bias is seen when investors sell winners too early. The pain associated with taking losses can keep investors from switching bear market losers to potential winners. Allison suggests that investors have a process for buying and selling investments that is disciplined, fundamentally sound and repeatable. We use the 200-day moving average to signal when we should buy and when we should sell. [New Year, New Strategy.]
- “The market has gone up too far and too fast. We are due for a correction.” This could signal something called “anchoring” or “reference point.” Anchoring occurs when a person assigns a fixed number to compare prices of an investment over a period of time. Most academics and investment professionals would agree that past price movements are poor predictors of future performances. During a new bull market, anchoring can lead to “market acrophobia” – the belief that markets are due for a correction if they jump up too far too fast. It should be noted that an investment’s past performance reveals very little about its current fundamental valuation and long-term prospects.
- “I will never buy stocks again.” This may signal the “snake bite effect” – investors take hefty losses in a certain asset class and become risk-averse. Investors should always keep their investment objectives, risk tolerance and capital market expectations in mind before investing. The snake bite effect could lead to an under-diversified portfolio or a portfolio that doesn’t fit with an investor’s objectives during a new bull market. [Things to Avoid When Investing in ETFs.]
A simple strategy for managing your emotions is trend following. We use the 200-day moving average to help pick spots in the market as well as to help us know when to sell. [How to Follow Trends.]
For more information on investing, visit our ETF 101 category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.