Many animal species run entirely on instinct. With brains too underdeveloped to understand why they take that next bite, but developed enough to know that they have to, instinctual creatures don’t seem to have a choice in anything they do.
Human beings are quite different. With highly developed brains, humans have developed intuition and the ability to make decisions, even those that may not be in your best interest. Nonetheless, your natural instincts drive your decision making far more than you might think.
Forbes once published an article explaining that your gut instincts are a driving force behind all of your career decisions. Your basic natural instincts are what drive you to be successful, to have children, to be the best human being you can be in all areas.
But what about investing? If your instincts have driven you to make the moves that you’ve made to become successful in life, why not let them drive your investment decisions? Then again, is that really a good idea? Should you let your basic instincts drive something as important as your investment decisions?
Pro tip: You can earn a free share of stock (up to $200 value) when you open a new trading account from Robinhood. With Robinhood, you can customize your portfolio with stocks and ETFs, plus you can invest in fractional shares. Sign up for Robinhood.
Is It Really Best to Follow Your Instincts When Investing?
It’s only natural to want to let your instincts guide you, especially if you’re doing something new. “Trust your gut” has become a commonly used expression. On the other hand, your gut is not intellectual, and the decision to make an investment is a rather complex one.
The truth is that your investment decisions are not among the choices you should make on gut instinct. If you decide to make investment decisions on instinct rather than making educated, research-based decisions, you’re gambling rather than investing.
The general impression is that stocks will gain in value over time. Historically, the S&P 500 has provided investors with nearly 10% in annual returns. However, it’s important to remember that, although the overall market is known for providing relatively consistent long-term returns, the market is an average that takes action from all stocks into account.
While some companies will produce tremendous long-term gains and generate annualized returns of well above 10%, others will go out of business, producing significant losses. That’s what makes diversification so important.
If you allow your gut to make your investing decisions for you, there’s a strong likelihood that it will make multiple bad moves. You’ll likely find yourself invested in stocks with too much competition, little by way of intellectual property, or products that simply aren’t selling, setting the stage for significant losses.
In some cases, beginner investors use their gut rather than sound logic to make timing decisions about when to enter or exit an investment. These are often emotional decisions, driven by the two main emotions associated with investing: fear and greed. When a stock is falling, fear of further losses may lead to an early exit, forcing you to accept losses that you could have recovered from. Conversely, when a stock is rising, greed can lead you to purchase more shares at high price levels. As the stock falls back down, the losses you experience from the portion of shares purchased at a high price eats into the gains you could have realized if you had simply stuck with your original investment.
The point here is simple: Whether your gut is telling you what to invest in, when to buy, or when to sell, you should ignore it. Let your feelings make decisions on love. When it comes to the market, the most profitable decisions are educated ones, made only after taking the time to research and get a detailed understanding of exactly what you’re investing in.
Where This Myth Comes From
Humans, like most other animals, are creatures of habit. When you do something over and over, the repetition creates a level of comfort, building habits that you continue to repeat, whether they are good or bad.
Using intuition to make difficult decisions is a habit that has been repeated for generations. Children in high school are often told to follow their gut when thinking about what they want to be when they grow up. At even younger ages, children are encouraged to go with their instincts when deciding what they want to do for their birthdays.
You probably heard the term, “follow your gut,” a hundred times before you even entered your adult years. Over time, this has built the habit of following your gut when making difficult decisions. You’re not alone. According to Harvard Business Review, 45% of executives now rely on gut instincts more than they do facts and research when running their business. The article outlines how prevalent using one’s gut is and why doing so is the wrong thing to do in most professional situations.
Because using your instincts to make tough decisions is a habit that has been ingrained in most people throughout their lives, it only makes sense that many want to trust their instincts when making investment decisions. So, the idea that it’s best to follow your instincts when investing is one that is born through the natural process of decision making and how you have been told to make decisions that you don’t quite understand throughout your life.
Why the Follow-Your-Instincts Myth Is Dangerous
In the stock market, instincts are akin to emotion, and one of the first lessons that beginners learn about investing is that emotional investing can lead to significant losses. It’s OK to follow your instincts when making the decision to call someone back after a first date, deciding to go a different direction with the decoration of your home, or any number of decisions that are matters of the heart. However, when it comes to decisions that can either make you or cost you money, following your gut isn’t the way to go.
The reason is simple: Your gut doesn’t know the difference between gains or losses — all it knows is what makes you comfortable. Your instincts don’t care about the underlying value of a stock you’re considering; it cares that buying that stock makes you happy.
For example, imagine the travel industry has struggled for several months or even years. You’ve wanted to travel for a while, and due to the low demand, prices are lower than you expected. Your gut tells you that low travel prices are going to boost demand, leading to a comeback in the travel industry. So, you decide to make an investment decision and buy three downtrodden travel stocks.
The problem in this example is that you didn’t do your research first. At the time you bought in, travel prices were low because a pandemic was taking hold. Soon, cruise lines and airports completely shut down operations. Two of the three travel companies whose shares you purchased were already up to their eyeballs in debt and now can’t afford to keep their doors open, leading to bankruptcy. You experience significant losses.
Avoiding losses like this would have been as simple as doing your research. In this example, looking into the companies’ financials and diving into why travel prices are so low would have told you that coronavirus was spreading and that travel was going to take a dramatic hit in the months — and potentially years — to come. Knowing this, you wouldn’t have made these investments and the losses could have been avoided completely.
A myth promoting a process that has a higher probability of producing losses than gains for investors is dangerous, there’s no way around it. That’s exactly what you get in the myth that you should follow your instincts when investing: a dangerous yet widely accepted notion that results in significant losses for investors on a regular basis.
The issue here is herd mentality. When a stock is rocketing, everyone wants to buy in under the belief that the stock will continue to fly. Conversely, when a stock is falling the herd is afraid to jump in for fear of future losses. The fact of the matter is that a stock is always at its lowest before a recovery and highest before a drop. You don’t want to buy on highs or avoid buying on lows, as your instincts would suggest.
How to Avoid the Urge to Follow Your Instincts When Investing
The fact that human behavior is driven by patterns and habits makes breaking habits extremely difficult. You’ve been told to follow your gut since you were a child, and you likely have a strong habit of doing so when making many kinds of important decisions.
So how do you break that habit when it comes to decisions about investing? How do you completely block out intuition and prevent emotional investing mistakes? There are a few steps you can take:
1. Learn About the Market Before Choosing Your Own Investments
Making your own investment decisions opens you up to an urge to follow your instincts. So, before doing so, it’s important to educate yourself. That doesn’t mean you should delay an entrance in the market — it’s more about how you enter the market.
If you are a newcomer with little to no knowledge of the market, there’s no shame in using an automated service like Betterment or Acorns. With these companies, you can set up a plan, starting with small amounts of money and investing more as you go. Once you deposit your investing dollars, you let the system do the investing for you. Betterment and Acorns use the money you’ve invested to purchase a wide range of ETFs and bonds, providing you access to a heavily diversified portfolio. This gives you the immediate ability to take advantage of the compound returns involved in long-term investments in the stock market while you get comfortable making your own decisions.
While Betterment, Acorns, or any of a long list of comparable services begin to invest and grow your money for you, take an hour out of each day to read about the stock market. Important basics include learning the lingo, understanding diversification and knowing the difference between stocks and bonds, and gaining a basic feel for how stocks are analyzed and researched. Once you have a good understanding of how the stock market works, your investment decisions will be based on your research, helping to push intuition out of the equation.
2. Choose an Investment Strategy and Stick to It
A well-defined investing strategy is a great way to keep your instincts out of the decision making process when investing. If you follow your strategy to the letter, your personal opinion is taken completely out of the equation, with your investment decisions being made based on the data rather than your emotions.
There are several established investing strategies that have solid records of producing compelling gains for those who use them. Some of the most popular of these strategies include:
- Value Investing. Value investing is the process of investing in stocks that have compelling valuation ratios, suggesting that buying at current levels provides a discount on future gains. This style of investing requires the stock to have specific qualities to be purchased and held in a portfolio, taking intuition completely out of the equation.
- Income Investing. Income investing is the process of buying shares in well-established companies that have a long history of slow, yet stable returns and a high dividend yield. The dividends create a paycheck, while the steady growth in the stock helps you take advantage of compound gains in the stock market. As you dig into income investing opportunities, your investment decisions will be driven by strong fundamentals and a history of dividend payments, pulling instincts out of the equation.
- Growth Investing. Growth investing is the process of investing in stocks that have experienced momentous growth over the past few years. The idea is that the upward momentum will continue, producing strong returns. When making growth investments, you’ll look for stocks that fall into specific growth parameters, helping to alleviate the risk of instinct-based investing.
3. Know When to Walk Away
Nobody is perfect. No matter what strategy you use, how much you know about the investing process, or how many measures you take to avoid instinctual decisions when investing, at some point, mistakes will be made.
When you’re making investing decisions and you notice that you’re starting to veer away from your strategy, the likely cause is that your instincts are starting to take over. At this point, it’s time to leave your portfolio alone and walk away. Do something to take your mind off of investing and come back to trade another day.
Breaking habits and veering away from your instincts can be difficult. However, when it comes to investing, it’s an absolute must. Allowing your gut to take control of your investment portfolio all but guarantees that you will experience losses you would have avoided by making research-and-data-driven investing decisions. There’s no other way to slice it.
Have your instincts ever led to losses in your portfolio? What do you do to break free of your instincts and make profitable, data-driven investment decisions?
Originally posted at https://www.moneycrashers.com/stock-market-investing-instincts/