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Investments Should Be Guided By Reason, Not Emotion

Written By: Linda Horn
By Linda Horn, CEO Capital Concepts

What makes for a good investor?

Driven by emotions more than logic, we typically buy high and sell low. What may surprise you is how big a penalty you can pay in the long run if fear and greed dictate your investment decisions. People in or near retirement seem particularly prone to such temptations. The financial media had plenty to talk about this spring and summer. How did you react to all the news?

As you ponder your own investor behavior, keep in mind this observation from the Dalbar report: "It is easier to make the right decision when the markets are rising and the fear of loss is on the back burner. The really smart decision, that most investors get wrong, is to invest when the market is down. If you don't know when to get out, it is better to stay in."

Most investors do not clearly understand their own risk tolerance. According to Nick Murray, author of several books including Simple Wealth, Inevitable Wealth, there are three great truths about risk tolerance.

First, far from being fixed, immutable, knowledgeable, and even quantifiable, risk tolerance in the individual investor is as volatile as are all his other emotions, because it is from his emotions, and not his intellect, that his risk tolerance is derived at any given moment.

Second, people change their risk tolerance in reaction to, rather than in anticipation of, market movements. That is, risk tolerance is essentially a lagged response. Thus, changing one's risk tolerance in response to market events, regardless of how one is changing it, must be a losing strategy, and a formula for substandard returns.

Third, the individual investor reacts to market movements by altering his risk tolerance pro-cyclically rather than counter-cyclically. That is, as prices rise, and especially if they rise sharply thus extinguishing value, the investor perceives that risk in those assets/markets is actually declining, when in fact it is rising.

The best approach for most investors is to have a well-diversified portfolio, ignore the noise from the media, continue to educate themselves about their finances, and be patient. By doing so you are on your way to being a good investor.

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