It’s usual for stocks on a share market to go up or down daily. And when companies navigate unusual global economic conditions, stocks and share markets can also be volatile - experiencing bigger rises or falls than usual. This can include anything from wars, global pandemics, supply chain issues, and even ships getting stuck in canals.
Investors can avoid making emotional investing mistakes by learning how to react to stock market shifts, however. Just like your household grocery budget, companies and exchange-traded funds adapt to changes in economic conditions. They may experience periods of growth as well as periods of decline, and just like the price of eggs their share value is likely to reflect those up and down shifts over time.
So how can people who are investing for the long term avoid emotional investing?
It’s perfectly normal for markets to shift
Since 1990, the US share markets have dropped in value by 10% or more on a dozen occasions – the worst being between 2007-2009, during the global financial crisis, when they crashed by more than 50%.
Longer periods of time when the share markets trend in any one direction, either appreciating or depreciating, are referred to by some people as bull markets or bear markets. It’s useful to know that the average length of a bear market - aka a share market dip - has historically been around nine months, and has happened on average around three times each decade. The average duration of a bull market has historically been just over two and a half years.
It’s perfectly natural to respond emotionally to market shifts
When faced with a portfolio that is dropping in value, you may grapple with the instinct to sell your shares. This is a natural stage in the cycle of investor emotions where some investors panic and sell off their investments. The disadvantage with this reactive investing response to market cycles is when the markets go back up again and the companies and ETFs return to growth mode, investors who sold their shares may miss out on investing benefits like dividend payouts and the long term effects of compounding growth.
On a practical level, there are a few things you might like to consider doing (and not doing) when there are bumps in the road and the share markets dip.
How to avoid emotional investing
Use long term investment strategies
History shows us that when investors are prepared to ride the ups and downs of the share markets (those bull and bear markets), they are more likely to come out on top over the long term. In fact, those who held a balanced share portfolio for the past 30 years may have enjoyed a cumulative rise on average of up to 750%.
The opposite of panic is deciding on your investing strategy and sticking with it. This means knowing thyself! In particular, knowing what you want to achieve with your investing, your risk tolerance, and what you plan to do when share prices drop and your heart rate rises.
Avoid panic selling
One way to not react like an emotional investor is to take a long term view. Think of the share markets as you would the property market. If your house drops in value, is your first instinct to sell it? Probably not. Your house is exactly the same - the same windows, doors, walls, footprint and location - so unless you need to sell it in a hurry, you’ll likely hold on and wait for prices to rise again before selling it. That’s because it makes sense.
It's similar to owning shares in a company. Whatever the share value on a particular day or month, it’s the same company, with the same products and services, same people and same capacity for growth. So unless you think something has fundamentally changed in a company or ETF that could affect its long term performance, a sudden drop in their value on the share markets may be simply part of the usual up and down market cycles. A quick internet search usually shows you if there’s negative news about a company; it's one starting point to understanding why share prices have dropped.
If your investing plan is to hold onto your shares for 5-10 years, then there may be plenty of time to wait out a share market dip (remember how those bear markets last around nine months?) and for the shares to rise in value again. If you no longer own those shares, you won’t get to realise the possible rise in value, but you will realise the loss. So, don’t panic.
Set clear investing goals
Be clear about the purpose of your investment portfolio. Is it for retirement? Perhaps it’s to help build a house deposit over time, or get mortgage-free sooner? Identify the companies that you’re committing to long term as ‘holds’ and have a timeframe in mind for when you plan to reevaluate your investments (and stick to that timeframe!). We’re talking years, not months.
Having a goal and knowing your plan will help you keep a clear head on the risks you’re prepared for and helps to keep investing decisions rational, not emotional.
Should you consider buying the dip?
Typically, share markets change daily and drop in value a little at least a couple of times a year. Every 3.5 years or so, the drops may be even more substantial. It's all part of the global economic cycle over time. Unless a drop in share price goes hand in hand with a change in the quality of an investment - such as something that negatively impacts a company’s ability to operate and grow - then you may want to think of a share price drop as your investment ‘going on sale’.
Many experienced investors celebrate the dips in a share’s value on a share market. Hailed as the greatest investor of all time, Warren Buffett told investors in his 2009 shareholder’s letter:
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
Just as many of us choose to buy clothes, shoes and homewares on sale, many investors like to buy shares in companies they believe in while they are cheaper.
Try to diversify
Think about the different types of investments available through the share markets and what percentage of your portfolio you want each to make up. This is called diversification. In simple terms, this is spreading your money across a range of investments and industries, which may include companies you believe in as well as ETFs such as index funds that track the performance of a range of companies on a share market, such as the top 500 leading companies.
An example of diversification may be investing larger amounts in ETFs that contain a whole basket of different companies or dividend-paying companies - sometimes referred to as Blue Chip companies - with smaller amounts invested in individual growth companies. Or diversifying across a range of sectors, so where one industry might dip, another may be on the rise.
Think about drip-feeding
Instead of spending a lump sum of money at any one time investing in a particular stock, you may choose to invest smaller amounts at regular intervals over time. Auto-invest can be a useful tool to help with this. Not only does auto-investing help to avoid emotional investing mistakes, investing becomes a habit and decisions aren’t made based on ‘feelings’ about how the market is performing at a specific time. It also helps investors buy shares at different value points over time, which is known as dollar-cost averaging.
Avoid timing the market
Timing the market is effectively trying to buy shares at a time when they are low value, and sell them when they’re at a high value. While it’s an investment strategy used by investment firms and speculators, many experienced investors, financial professionals and academics believe timing the market is ‘impossible’. Without having access to a breadth of industry experience and sophisticated financial tools, for the average investor, trying to accurately predict future movements of stocks or share markets by timing the market is tricky. So if you’re investing for the long term, it’s probably a strategy best left to the experts.
Just like death and taxes, you can probably be certain of cyclical market volatility from time to time. But always know that you are in charge of how emotions affect investment decisions and whether you choose to react to changes in market conditions.
As famous investor Benjamin Graham said, "The individual investor should act consistently as an investor and not as a speculator.” So, keep calm and invest on!