How to Make Rational Investing Decisions

Investing involves setbacks, confusion, frustration, uncertainty, anxiety, and disappointment. How you respond to such things will play a key role in your success — or the lack of it.

Your investment plan is more likely to succeed if you can overcome the common psychological challenges of investing. This article by investing veteran Paul Merriman showcases several tools that can help. But only you can apply these tools and keep yourself on the right path.

It’s relatively easy to prescribe an investment plan that is likely to work well if it’s followed diligently. The hard part is keeping yourself from derailing your own plans. One of the biggest mistakes investors make is underestimating the power of their emotions. If you take the time to understand the psychology of successful investing, you’ll make your life more pleasant and you’ll probably have more money to spend in retirement and leave to your heirs. But if you ignore this topic, I promise you will pay for doing so.

Many investors get in and out of the stock market from time to time depending on whether they think prices are relatively high or relatively low. Some have mechanical timing systems to guide them, but many people believe they can successfully make their own decisions about when to get in and when to get out. In hindsight, the majority of such moves are counterproductive.

When stock prices are relatively high, financial risk is also high and the opportunity for gains relatively low. Yet high prices, ironically, mean low emotional risk for investors. People find it easy to buy investments that have been going up. On the other hand, when prices are relatively low, financial risk is also low; the opportunity for gains is high. But low prices mean high emotional risk. Again ironically, investors find it hard to buy low-priced investments that have been beaten up in the market and whose near-term prospects seem bleak.

There’s no getting around one very basic truth about investing: The way to make money is to buy low and sell high. But our emotions, by trying to bring us comfort, work against us and try to persuade us to do the opposite. In the short run, comfort is very gratifying. But in the long run, comfort always has a cost.

Investors who crave quick, easy answers and peace of mind should expect lower long-term returns. Think about diet and exercise. It’s no great mystery how to eat sensibly and exercise regularly. There’s little dispute that doing so makes people healthier, happier, and likely to live longer. But knowing the right things to do is not enough. To get results you must somehow get yourself to do the right things, while you avoid doing counterproductive things.

Psychology is the key. If you just do what you feel like, you’ll most likely eat too much, you’ll eat the wrong things, and you won’t exercise as you should. What “feels good” at the moment is usually a lousy guide to what’s really in your best interest. This is just as true of investing as eating.

Throughout your life as an investor, you will be goaded by the media, which will do its best to keep stimulating you with entertainment that’s carefully disguised to look like insight and advice. The aim of the media is not to help you. It’s to keep you coming back for more — to deliver your attention to advertisers. Unless you realize this, you will be constantly misled.

You can be sure that the investment profession understands psychology very well. Wall Street doesn’t really care how you invest your money. The industry’s primary goal is to get you to change whatever you’re doing. That’s how Wall Street makes money. To that end, investors are barraged night and day with sales pitches, some obvious and some masquerading as objective investment advice or insight. All of it is designed to get people to buy and sell. To be a successful investor, you’ll have to figure out how to deal with all that.

Your style in the driver’s seat

Investing is in some ways like driving a car. The route you need to take may be pretty straightforward, but your attitude, skills, and psychological makeup will play a major role in shaping your actual experience of the journey. When it’s your money at stake, you should be the one in the driver’s seat, even if you are taking directions from someone else. The best way to keep your hands on the wheel is to have a plan that will work for you and then stick to it. The best way to do that is to know the difference between your financial needs and your emotional needs.

Ultimately, the solution to many investors’ psychological challenges is pretty simple. Because your emotions will never be a reliable guide, your best bet is to put it all on automatic. That means automatic savings, automatic investing, automatic asset allocation, automatic rebalancing, and automatic distributions in retirement.

There’s an interesting parallel between the way people drive and the way they invest their money. Good drivers practice defensive driving techniques. If you know what to look out for on the highway, you can greatly improve your chances of getting to your destination safely. I want you to be a good defensive investor. To do that, there are three things you need to watch out for — your own emotions, the manipulations of Wall Street, and the misleading media. On one level, investing is about knowing the right things to do, then doing them.

But in the real world, investors are driven more by emotions than logic. Mark Hulbert, a New York Times and MarketWatch columnist whose business has been to study investment newsletters since 1980, said it well during an interview on my Internet radio show: “Our intellect is basically no match for our emotions. As we see over and over, emotions will trump the intellect almost every single time.”

As an investor, your emotional adversaries are likely to be fear, greed, impatience, and frustration. How you deal with them will have a huge effect on how much money you are at risk of losing. Impatience can be deadly.

In traffic jams, impatient drivers often pay lots of attention to what lane they are in and how other lanes are doing in relation to theirs. If the other lane seems to be moving faster, they will often swerve over to cut in front of somebody else. Some drivers do this repeatedly, taking every opportunity to gain some small advantage for themselves. Those drivers may gain a few seconds. But in the process, they raise the level of danger and annoyance to themselves and everybody around them. In investment terms, drivers like that take on much more risk in return for uncertain (and often elusive) gains.

Impatient investors often watch the market like hawks. They want results, and they want them now. Impatient investors are easy prey for the investment industry. They can be lured to change lanes, then change lanes again, always seeking a competitive advantage. Unfortunately they often wind up as “road kill,” retiring to the shoulder of the road with their capital in money market funds while their more patient counterparts build wealth in the slower lane.

Patient investors may wait for decades before they reap their rewards. But they are more likely to be able to retire comfortably — and more likely to sleep better along the way. So here’s a piece of advice that may be worth remembering: Every time you invest some money, remind yourself to invest some patience along with it. You will be rewarded.

When you drive, you have a certain style. You may not notice your style, but I promise you that the people who ride with you do. There’s a certain amount of frustration you are willing to tolerate from other drivers who don’t behave as you think they should. And there’s a way you react when that frustration exceeds your limit. On a clogged freeway, do you weave from lane to lane or rush to the next exit hoping to find a better route that other drivers haven’t discovered? Many people change their investments mainly to relieve frustration. The odds of success are not in their favor.

Watch out for your expectations

An important part of dealing with your emotions is managing your expectations. Of course you want to make money from your investments. And if you follow a sound investment plan, you will. But I can guarantee this: You won’t make money all the time. Unless your investments are limited to Treasury bills or other cash equivalents, your investments at some point will go down in value. What matters is not whether that happens but how you deal with it.

In fact, you should hope you don’t make big gains on your investments right away. The reason is psychological, not financial. If you make a lot of money quickly after you invest in something, it will almost always be a random event. But to your mind, that random event will seem very important if it happens in the first hours, days, or weeks of your investment.

I’ve observed over the years that investors are much more likely to stick with investments that “reward” them very early in the game. If a fund shoots up 10 or 20 percent in the first six months you own it, at some level you will develop an emotional bond with it. This bond will cloud your judgment. No longer will this fund be merely a tool that you use to accomplish something. Instead, it will have become an ally or a friend, something you feel you can “trust” to take care of you. On the other hand, even the best investment plan in the world can have very little emotional appeal if it loses money in the first six months that you own it. You will develop an emotional aversion. You’ll start to regard this investment not as a tool but as a bad idea, a sort of adversary that gives you bad vibes.

Your goals should be sensible

One of your most important psychological allies will be a set of smart goals. Many people say their objective is to beat the market. But I don’t really believe that, and I’ll tell you why. If all you want is to beat the market, then in a year when the market (however you define it) is down 40 percent, you should be supremely happy to lose “only” 35 percent of your money. Do you know anybody who would brag to his or her family about losing 35 percent? I don’t. In a good year, if the market is up 30 percent, you’d be compelled to complain to your family if your portfolio went up only 25 percent as if you were a failure.

If you aren’t clear about your objectives, you can experience anxiety no matter what results you get. To investors, anxiety is a powerful force that can tempt you to switch investments when you shouldn’t.

Veteran investors know that the market does not reward all investors at the same time. Older investors should want higher stock prices so they can convert their investments into cash for living expenses. Younger investors should want lower prices so they can buy a piece of the future at a reduced price.

What should your objective be? There’s no right answer for everyone. The only wrong answer is to have no answer, or to believe that you can and should achieve every possible financial goal at the same time.

Watch out for Wall Street

Even when you have your own emotions under control, you’ve still got to deal with Wall Street. Managing risks is at the heart of successful investing, and you should always focus your attention on this when you’re considering a new investment. But you’ll rarely find an investment adviser who wants you to do that. The investment industry has learned that when people confront the emotions associated with losing money, most folks will flee before a salesperson can make a dime in commissions.

The industry doesn’t want to talk about preparing you for the inevitable bad times, even though that is what you need. The industry just wants to make money while there’s money to be made. That happens when commissions are generated, and that happens when you do something. Optimism sells, and it’s no accident that Wall Street is organized to make you think higher returns are just a transaction away. If you just sit tight, your broker doesn’t make any money. Everybody in the business has a better idea for what you should do with your money, and they’re all eager to do it for you.

As investors, we can choose every day from thousands of mutual funds, thousands of managers, thousands of individual stocks as well as many other financial products and plans. It’s easy to be a frequent trader. If you wake up in the middle of the night with an investment idea or fear, you can find a broker who will execute a trade for you immediately on the Tokyo or London exchanges.

The industry is highly motivated and highly trained (to say nothing of highly compensated) to do whatever it takes to get your money under management. Competition is fierce, and the sales and marketing forces will use every trick they can to lure you to sign on the dotted line.

Watch out for the media

Anxiety, one of an investor’s major enemies, is goaded by the media. The job of the media is not to look out for your interests and make you a better investor. Perhaps you think the folks at Money and other financial websites have done your homework for you. Unfortunately, that’s not how it really works. In real life, the job of the media is to keep your attention for the benefit of advertisers. As if that wasn’t bad enough, many of the articles in the financial media were spawned in the public relations departments of mutual fund companies, brokerage houses, or other firms that make and sell financial products.

Media companies learned long ago that it’s next to impossible to sell magazines and newspapers, or to build audiences for television shows and websites, unless they have something new, different, exciting, and better. Which would you pick up first — a magazine promising to tell you about a hot new investment or a magazine with a cover story saying a 25-year-old investment plan is still the best one?

Every hour, every day, every week, every month the media have to hawk something new and different. If you are persuaded to buy a fund or a stock this month, you’ve got to be tempted to do something else next month. Otherwise, you’ll be just one less reader (or listener or viewer) who can be delivered to advertisers next month.

The media offer a parade of experts who slice and dice every part of the financial world before your eyes and ears, often 24 hours a day. And how useful are all these experts? Not very. For any financial topic you can think of, I could find at least two highly qualified experts who would take opposite positions on the meaning of any particular situation. The media like to quote these people’s views as if they were facts instead of interpretations and guesses.

Some big brokerage houses employ people whose only job is to answer media questions about the pulse of the market. None of these people has any reliable way to know why the market is doing whatever it’s doing. But does that stop them? Not a bit!

The restless client

I want to tell you a story about a client who couldn’t separate his carefully plotted strategy from what was happening in the broader market.

After extensive discussions with this very smart client, we set up a worldwide balanced account for him with four equally weighted categories of assets: U.S. stocks, U.S. bonds, international stocks, and international bonds. We expected this mix would give him just the right combination of limited risk along with reasonable expected returns that would meet his needs. There was no question that he completely understood what we were doing.

About six months later, he called to say he was quite upset that his account was underperforming the Dow Jones Industrial Average, which had been doing quite well and which had been in the media spotlight. On a rational level, this client’s complaint made no sense. Half his portfolio was in bonds, and only 12.5 percent was invested in large-cap U.S. stocks like the 30 that make up the Dow Jones index. There was no way his portfolio could mirror the Dow. What could he have been expecting?

When I reminded him that we purposely set up his account to make sure it did not match the Dow, he assured me he understood that on an intellectual level. But his anxiety was not based on reason. His emotional side told him that he had come to an investment professional for money management, and now he felt as if we were not on top of his account and the market.

His emotional reaction was akin to turning on your car radio when you are stopped cold on a freeway, and then getting angry when you hear that several other freeways are wide open. It’s an understandable reaction, but not very rational and not very useful. We worked through this issue with him, and he stuck with his carefully crafted plan.

There are always two lists

Many people think they have to figure out whether the market is too high or too low. But can they do it? Let me describe a mental exercise I do for fun every now and then, one I often present in the workshops I lead. I call it “the two lists.”

The folks on Wall Street always have an “A” list of reasons the market is almost certainly going up and a “B” list of reasons it’s almost certainly headed downward. Every item on each list is plausible and seems important. I usually believe everything on each one. The problem is that the “A” list is just as solid as the “B” list, and vice versa. All the changing and conflicting items on these lists give you no rational basis for making investment decisions.

For example, here’s a 2021 version of the two lists:

A. Reasons the market will go up: The post-pandemic reopening in the U.S., and eventually elsewhere in the world, will continue to release pent-up demand, driving robust economic activity and higher corporate earnings. Concerns about inflation will wane as supply bottlenecks ease and stimulus impacts fade. Interest rates remain near historic lows, which will continue to drive money toward stocks as investors — including millions of younger people who are new to the investing game — seek a decent return on their money.

B. Reasons the market will go down: Market valuations are too high and a time of reckoning is overdue. Once the post-pandemic pent-up demand is satisfied, economic growth will slow markedly. Higher taxes from Washington will sap profitability and put downward pressure on stock prices. Inflation will persist, aided by a falling dollar and massive government spending. Inept policy moves by both the government and the Fed could spark a return to 1970s-style “stagflation” — an extended period of higher prices but with little economic growth. All of these things will make political and social instability even worse, further spooking investors.

Each of those lists could be expanded by a mile. If you had to choose one of them, how would you do it?

Unfortunately, many investors don’t know what they believe and why they believe it. As a result, they adopt a view of the market based on who they heard when they happened to be in a receptive mood. I hate to think how many people make major decisions that affect their financial future based on somebody’s personality or charm or the emotional content of a particular point of view. The right way to deal with most broadcast financial journalism is to either change the station or turn off the radio or TV. The wrong way is to make investment moves based on what you see or hear on these programs.

My answer to dealing with your emotions

Here’s the straight scoop: From time to time you will know exactly what you ought to do as an investor. And you simply won’t want to do it. The solution is to put your investments on automatic pilot. Have money deducted from your paycheck and deposited in a 401(k) account or automatically withdrawn from your bank account and put into a mutual fund’s automatic investment plan. Make this decision once, not every time you get paid. Pay yourself first (before you spend any money) and pay yourself automatically.

There will be times when you’ll want to follow some interesting idea you hear about. Don’t do it. To remove (or at least greatly reduce) temptation, make sure your new investments are automatically being allocated in the right way. There will be times when you won’t want to go to the trouble of rebalancing. If you can, make this happen automatically once a year.

Your best defense against your emotions and against the influences of Wall Street and the media is to get things figured out once, then let other people and their computers carry out your wishes. That will make your life a lot more pleasant. And it will certainly make you a better investor.