Investing with emotion is dangerous because it suggests that our interests and ideas for what we like is better than what is actually fundamentally a great investment. You can invest in what you know and what you like, but you cannot at the expensive of other stocks or securities that you completely ignore because you d not like them or are not familiar with them.
This phenomenon even occurs with penny stock traders and Forex traders. Mining penny stocks for example might be more appealing to you than biomedical or software. You might have a preference for the Swiss Franc if you are of a Swiss background than you would a better trade. These might seem insignificant but they can have a dramatic impact on your earnings short term as well as long.
How do I Prevent Myself from Emotional Investing?
One of the most common and easy ways to prevent emotional investing is through an ETF or mutual fund. These are great opportunities because both would not rely on your interests for their success. They hold the same securities as they did when you bought them and if they don’t they change not on your decision or emotion but that of the fund manager. Of course there are certain funds and ETF’s that cater to specific interests and emotions that you will have to be aware of. Broad market or market cap based funds based funds are your best answer.
Diversification Can Prevent Emotional Investing
If you are not disciplined enough to buy into an ETF or mutual fund you can still invest with emotion by ensuring a greater diversity of your holdings. Your emotional investing might lead you to own Google, Yahoo and Facebook because you like using the internet and you understand it best. If the market tanks you are in really bad shape. And many would argue this whole industry cannot go up at the same time. To hedge your risk you would diversify by buying other securities to counter those you already own.
Diversification is somewhat tricky and always a matter of contention from investors. However as a general rule, owning a great diversity of stocks will enable you to benefit from various trends in the market and prevent less damage to your portfolio if one sector or security begins a bear market. It may not seem significant but buy just added three more diverse stocks to those three internet ones you already own you are able to achieve greater diversity. Of course you want to make sure you don’t give too much weight to one stock over another based on emotion.
Emotional Investing is Peer Pressure
You see it all the time on leading financial news and stock analysts websites. They purport to have the latest and greatest pick or stock to buy that is sure to make you rich in the short or long term. They advertise the ability to beat the market again and again through investigation and knowledge that only they can provide!
These websites purposely hope to get you emotional about investing. They are trying to encourage not only your interests but a necessity for action and often urgent action. This is the same as reacted to a hot stock pick from a coworker from the water cooler. These were far more common before the advent of the internet but nevertheless can be extremely difficult to overcome. Imagine your discomfort at a coworker making a killing on a stock you never even thought of. You feel discouraged, embarrassed, and wonder, why didn’t I think of investing in that stock? The urgency and the emotion to invest takes over.
The Solution – Fundamental and Technical Analysis
The best tool at your disposal to prevent emotional investing is to use the research tools the best use, fundamental and technical analysis. Fundamental analysis relies on the study of the fundamentals of a company, such as their earnings, debt, dividend, market cap, etc. These will allow you to not consider emotion and look at pure data. Technical analysis relies on the use of charts and patterns. Investors only buy and sell the stock in question by finding a particular pattern in the charts or graphs. Acting on these prevents emotional investing as well.