You’ve spent hours researching the best investment choices, analyzed financial reports, and carefully considered your options. Then the market drops 10% overnight– and suddenly, all that rational planning goes out the window. Fear takes over, and you find yourself selling at the worst possible moment. If this sounds familiar, rest assured– you’re not alone.
The human brain simply wasn’t designed for modern financial markets. Our emotional wiring, which helped our ancestors survive dangerous situations, now works against us when making investment decisions. Understanding how emotions influence your financial choices and learning practical ways to manage these emotional responses can be the difference between financial success and costly mistakes that compound over decades.
The Costly Reality of Emotional Investing
What the Research Shows
The impact of emotional decision-making on investment returns is measurable and substantial. The average equity fund investor earned over 10% less than the S&P 500 in 2021, according to a recent DALBAR study of investor behavior. This marked the third-largest underperformance gap ever recorded since the study began tracking investor behavior in 1985.
Over longer periods, the numbers become even more startling. DALBAR’s recent research, which has tracked investor behavior for over three decades with historical gap analysis dating back to 1985, shows this underperformance is a persistent pattern. The 2024 findings underscore that it wasn’t market performance that held investors back, it was behavior. When compounded over 20 or 30 years, this difference can cost investors hundreds of thousands of dollars in missed returns.
The Brain Under Financial Stress
When financial markets become volatile, your brain undergoes a fundamental shift. Rather than the rational prefrontal cortex, the fear- and anxiety-driven amygdala becomes active. This biological response makes you more likely to react on instinct rather than logic.
Common Emotional Biases That Hurt Returns
Fear and Loss Aversion
Loss aversion is one of the most powerful emotional forces affecting investors. Research shows that people feel the pain of losing money about twice as much as they enjoy gaining the same amount. This asymmetry leads to several costly behaviors.
During market downturns, fear often drives panic selling. Investors sell their holdings to avoid further losses, even though historically, markets have recovered from previous downturns. This fear-based selling typically happens at the worst possible times, locking in losses and missing subsequent recoveries.
Greed and Fear of Missing Out (FOMO)
On the flip side, greed and Fear of Missing Out (FOMO) can be equally destructive. When markets are rising or hot investment trends dominate headlines, the emotional trigger shifts from fear of loss to fear of missing out on big gains. This can lead to chasing performance, buying high, and investing in areas you don’t understand simply because they’re popular.
The cryptocurrency surge and meme stock phenomena of recent years provide perfect examples of FOMO driving investment decisions. Many investors jumped in near market peaks, driven by stories of others making quick profits, only to panic and sell when these investments experienced volatile downturns..
Overconfidence and Anchoring
Success can breed its own problems. Overconfident investors tend to trade more frequently, believing they can predict market movements better than they actually can. This overactivity typically leads to higher costs and lower returns due to frequent trading and poor timing decisions.
Anchoring bias causes investors to fixate on specific numbers or price points. You might refuse to sell a stock because it’s below your original purchase price, or you might wait for an investment to return to its previous high before selling, missing opportunities in the process.
The Herding Instinct
Following the Crowd
Humans are social creatures, and this extends to financial behavior. Herding behavior leads investors to follow the crowd, buying when everyone else is buying and selling when others are selling. This often results in the classic mistake of buying high and selling low.
Media coverage amplifies herding behavior. When financial news focuses on market crashes, it reinforces selling pressure. When coverage turns positive, it can fuel buying frenzies. Social media and online investment forums can make herding behavior even more intense and immediate.
Breaking Free from the Pack
Successful investing often requires doing the opposite of what feels natural or what everyone else is doing. This contrarian approach isn’t about being different for its own sake—it’s about recognizing when emotions are driving market behavior and positioning yourself to benefit from others’ emotional mistakes.
Practical Strategies to Manage Emotional Investing
Create an Investment Plan
A well-documented investment plan serves as your emotional anchor during turbulent times. When markets get volatile and emotions run high, referring back to your written plan helps you remember your long-term goals and predetermined strategies.
Your plan should include your investment timeline, risk tolerance, asset allocation targets, and specific criteria for making changes. Having these decisions made during calm periods helps you avoid making impulsive changes during emotional periods.
Implement Dollar-Cost Averaging
Dollar-cost averaging involves investing a fixed amount regularly, regardless of market conditions. This strategy removes the emotional burden of trying to time the market and can actually benefit from market volatility by buying more shares when prices are low and fewer when prices are high.
Automatic investing takes this concept further by removing the temptation to skip contributions during scary market periods. When investments are automatic, emotions have less opportunity to interfere with your long-term strategy.
Use the 24-Hour Rule
Before making any significant financial decision based on market news or emotions, implement a 24-hour waiting period. This cooling-off period allows your rational mind to regain control and helps you avoid impulsive decisions you might regret later.
During this waiting period, review your investment plan and consider the long-term implications of the decision.
Measure risk understand time horizon
You should measure the risk in your portfolio before volatility events happen. While we know a given portfolio can’t predict future success or failure, we can measure risk and understand how our portfolio may behave in both market booms and market busts.
Lifewise, it’s crucial to understand time-horizon when we invest our money at risk. In the shorter term, stock market investing is completely unpredictable. Over longer periods of time, a diversified stock portfolio becomes more and more effective in growing wealth and beating inflation. The longer it will be until you need to make withdrawals from an account, the more stock-based your portfolio can potentially be, because you’re focused on what the portfolio looks like in 10, 15 or 20 years.
Focus on Process, Not Outcomes
Markets are unpredictable in the short term, but good investment processes tend to work over longer periods. Instead of obsessing over daily portfolio values or short-term performance, focus on whether you’re following sound investment principles.
This might mean rebalancing your portfolio regularly, continuing to save consistently, and staying disciplined about your asset allocation regardless of recent market performance.
Building Emotional Resilience
Education and Understanding
The more you understand about market history and normal market behavior, the less likely you are to panic during downturns. Knowing that markets have experienced numerous crashes, corrections, and recoveries can provide perspective during difficult periods.
Professional Guidance
Working with a financial advisor can provide an objective perspective when emotions cloud your judgment. A good advisor serves partly as a behavioral coach, helping you stick to your long-term plan when your emotions push you toward poor decisions.
Advisors can also help you understand your own behavioral tendencies and craft strategies that align with, rather than resist, human nature.
Regular Portfolio Reviews
Schedule regular portfolio reviews during calm periods rather than reacting to market events. These periodic check-ins allow you to make thoughtful adjustments based on changed circumstances rather than emotional reactions to market volatility.
During these reviews, assess whether your asset allocation still matches your goals and timeline, whether you need to rebalance, and whether any life changes require plan modifications.
Work With Us
Emotions are a natural part of being human, but they can be devastating to long-term investment success when left unchecked. The research clearly shows that emotional decision-making costs investors substantial returns over time, but the good news is that these behavioral traps can be overcome with the right strategies and support. By understanding your emotional triggers, implementing systematic approaches to investing, and maintaining a long-term perspective, you can avoid the costly mistakes that plague many investors.At Brogan Financial, we understand that successful investing isn’t just about choosing the right investments—it’s about helping clients manage the emotional challenges that come with market volatility and long-term planning. Our team combines comprehensive financial planning with behavioral coaching to help you stay disciplined during both bull and bear markets. We’ve seen firsthand how emotions can derail even the best-laid financial plans, and we’re here to provide the objective guidance and support you need to achieve your long-term financial goals. Contact Brogan Financial today to learn how we can help you build a disciplined investment approach that works with human nature rather than against it, and don’t miss Jim Brogan’s weekly insights on managing your finances and retirement planning by tuning in to More Living with Jim Brogan on Saturday mornings, your trusted source for practical financial guidance throughout the East Tennessee region.
