Why Managing Your Emotions Is Key to Smart Investing

Whether you are just beginning to invest or have been at it for a while, the ups and downs of the market can make you feel like you’re riding on an emotional roller coaster. The ride can be exhilarating one moment and scary the next. The rush of intense and sometimes conflicting feelings is natural when it comes to matters of money; however, allowing your emotions to dictate your investment decisions can be costly and prevent you from reaching your financial goals.

The era of 24-hour news supplies a steady flow of information to our daily lives, but the barrage of headlines can also feel like we are running from one extreme situation to the next. For investors, that can mean trying to make sense of the latest stories about runaway inflation, concerns about the banking industry, geopolitical tensions or rising interest rates. And while it is good to be informed, it’s also important to keep your emotions in check to prevent yourself from making investment moves at what could be the worst possible moment. Investor emotions typically evolve and coincide with an investment cycle, as shown below.

While investors may feel a wide range of emotions on any given day, the two most prevalent that typically spark action are fear and greed. The fear of the unknown or the potential of continued losses on an investment that’s declined can be potent, and it often can be enough to drive investors to settle and sell at a loss.

Fear can make a bad situation worse

Short-term volatility is a normal part of investing, but the short-term impact of significant movements can shake investors’ nerves. However, historical trends between 1926 and 2022 show that annual returns of stocks have been mostly positive. In fact, since 1926 one-year returns for the S&P 500 have been positive 73 percent of the time, and five-year annualized returns have been positive 87 percent of the time. While investing for the long term cannot guarantee the elimination of losses, over 15-year rolling periods stocks have not had a period of negative returns.

Selling in a falling market may lock in losses that can take years to recover from. Investors who stick to their financial plan despite periods of volatility are often rewarded with more attractive long-term returns. Sitting on the sidelines in cash can lead to negative real returns when factoring in inflation, compared with the 10.6 percent compounded annualized returns of the S&P 500 from 1970 through the first half of 2023.

Over the course of our lifetimes, we have endured political uncertainty, recessions, wars, social unrest and, most recently, a protracted pandemic that has shaped our country. Despite the wall of worry those events created, the stock market persevered—since 1970 the annualized total return of the S&P 500 is over 10 percent. Investors who took the slow and steady approach by investing $1,000 in 1970 would have had $191,048 by the end of 2022.

Too much of a good thing

Researchers continue to explore the impact that a positive outlook on life has on physical health. Studies suggest it may increase your life span, provide a boost to your immune system, and lower your overall level of stress. However, when it comes to investing, a little optimism is a good thing; too much can lead to overconfidence and rash decisions. In fact, as the chart below shows, consumers are often most confident in the economy at exactly the wrong time.

Getting caught up in the rush felt when a particular investment is performing well can lead investors to pour money into an asset class in hopes of realizing even greater gains. In doing so, asset allocation plans can get distorted and lead to high levels of risk concentrated in just a few stocks or a single asset class.

Overconfidence in investing can lead to chasing the performance of the latest hot stock or asset class only to see returns turn negative when overinflated valuations return to normal. An example of this occurred during the so-called “dot-com” era of the late 1990s. At the time, the internet was in its infancy, and technology stocks were soaring as investors rushed to get in on the enormous potential of the internet. From 1995 until its peak in March 2000, the tech-heavy NASDAQ Index rose by more than 570 percent before the bubble burst. When it did, the downfall was even more swift, with the index losing 77.9 percent of its value from peak until it reached its bottom in October 2002. It wasn’t until April 2015 that the index reached the high it had hit in March 2000.

The unfortunate reality of math for investors is that gains and losses aren’t linear. That means recouping a 10 percent loss in your portfolio requires an 11 percent gain, but the math gets worse as your losses become larger. For example, a 40 percent loss requires a 67 percent gain.

While no investment plan can guarantee you’ll never see a loss in any given year, chasing performance by piling into the latest hot stock or asset class can lead to concentrated risks that could take years to recover from in the event of a sharp sell-off like the type that occurred during the dotcom era.

Avoiding emotional pitfalls

Emotions are what make us human. They make our lives richer and more meaningful. However, they shouldn’t cause you to make significant changes to your investment strategy. Staying the course with your financial plan requires determination and the ability to withstand the occasional emotional impulse to drastically change direction. Maintain regular meetings with your Northwestern Mutual advisor when times are good, and adjust on your terms, not the market’s. A disciplined, long-term strategy is designed for your financial goals—no matter what stage you are in or where you are starting from—and stress-tested to handle shallow or deep market swings. Then you don’t have to worry about timing the market or reacting because the conditions are already built into your plan.

The fact is, wealth isn’t generated only when times are good but also by the decisions you make when the markets are under pressure. While others feel the need to react to the daily drip of news and speculation, we’re able to tune out the noise. Our ability to remain steadfast and use it as an opportunity for growth—helping capture the upside when the markets eventually recover—comes from our long-standing commitment to drive value over time. We’ve seen that playing the long game tends to win, generation after generation. 

Charts are for illustrative purposes only and not intended as a recommendation. Past performance is not a guarantee of future results. All investments carry risk, including potential loss of principal, and no investment strategy can guarantee a profit or completely protect against loss. Indexes are unmanaged and cannot be invested in directly.