Story last updated at 12/10/2008 - 11:29 am
Warren Buffett follows this rule of investing: "Be fearful when others are greedy and be greedy when others are fearful."
We all could take a page from that playbook.
When it comes to investments, emotions can play a big role in our decision-making, often to the detriment of our portfolio. Historically, individual investors have reacted emotionally to challenging stock market cycles, leading to disappointing returns.
It's human nature to want to take action when the market takes a down turn and you watch your hard-earned nest egg diminish. And when the market is soaring, it's difficult not to share in the optimism and buy even as the market is about to peak.
Investors who trade based on emotions, though, often make the mistake of expecting that the current market trend will continue - positively or negatively - instead of positioning their portfolio based on long-term averages and investment goals.
And in a downturn, we forget that moments of extreme negative investor sentiment are generally followed by double-digit positive stock moves during the following 12 months, and that the bear market will soon give way to a bull. Consider investor sentiment lows in 1975, 1980, 1990, 2003 and 2005. The market rebounded on average 23 percent in the following 12 months.
So how to you keep your emotions in check?
Cash on hand: Keep some liquid assets in reserve - cash or cash equivalents. This can help reduce your concern over short-term market movements and help you stick with your long-term investment plan.
Asset class diversification: Your long-term asset allocation - how you allocate your money among investments such as stocks and bonds - typically accounts for 77 percent of the variability of quarterly investment returns. The more you are concentrated in one asset class, the more dependent you are on the returns of that asset class. Allocating your assets toward a mix of investments helps to reduce market risk to your portfolio.
Diversification within each asset class: Most investors often have too narrow a view of diversification, thinking they are adequately diversified if they have 30 or more stocks, a little international exposure and a few money managers. The problem is that these investments are highly correlated - they often tend to move in generally the same direction. Let your investment professional review your portfolio and adjust it as needed to ensure it is appropriately diversified.
Time horizon - when you need the money: Always keep your "time horizon" in mind. You can typically afford to take on more risk if you have a longer time horizon. Your time horizon can help you keep a healthy perspective when the market dips.
Discipline: Once you have identified the long-term asset allocation/investment plan that is appropriate for you, stick with it (unless changes in your goals or personal circumstance require revisiting your asset allocation).
Difficult as it may seem at times, the key to overcoming emotion is to stay disciplined and stick to your long-term plan. Don't let media reports and the herd mentality drive your decision-making process. The smart choice often is to keep your eye on your long-term strategy, not short-term peaks and valleys.
JoEllen Weatherholt is an investment manager for Wells Fargo Private Client Services in Alaska. She is a Certified Financial Planner (CFP) and member of the Financial Planning Association and Society of Financial Services Professionals. She can be reached at (907) 265-2150 or firstname.lastname@example.org.