Getting your money right: How to avoid emotional investing

Welcome to CNBC Select's advice column, Getting Your Money Right, where financial advisor Kristin O'Keeffe Merrick will be answering your pressing money questions. You can read her last installment here on if a lower credit score can get you a better mortgage. Have a question you want to ask? Send us a note at AskSelect@nbcuni.com.

Dear Kristin,  

I am a relatively new investor and am realizing that I've become rather emotional when it comes to making decisions about my portfolio. I know that's probably not ideal when managing my money. I am hoping you can walk me through these emotions and help me come up with some better tools so I can make better investment choices.  

Signed,  

Nervous in Nashville  

Hi Nervous!  

This is one of my favorite topics because we get to talk about feelings and money! It shouldn't be a surprise that when we make choices about our money (something that is incredibly complicated and emotional for many people), some weird stuff bubbles to the surface.  
 
There are all types of emotional pitfalls when it comes to investing. No one likes to lose money, right? But investing money is a risk we need to take and with that risk comes the fear of loss. Conversely, making money is fun! But when is it the right time to proceed more cautiously? Entire books have been written on behavioral finance, but let's look at some of the more common problems investors face.  

In my opinion, the fear and greed index is one of the more fascinating concepts in investing. It's a tool to gauge investor sentiment by quantifying the prevailing emotions of fear and greed among investors (which in turn influences market behavior).

The index typically ranges from 0 to 100, with different versions and methodologies used by various providers. A reading closer to 0 suggests extreme fear (think March of 2020 when Covid restrictions were taking effect), indicating that investors are pessimistic and may be more likely to sell or avoid investing.

On the other hand, a reading closer to 100 indicates extreme greed (think peak bitcoin mania), suggesting that investors are optimistic and may be more inclined to buy or invest aggressively. 

People create a fear and greed index out of several variables, including market volatility, trading volume, put/call options ratio, the breadth of market advances or declines, and various technical indicators. By analyzing these inputs, the index attempts to quantify the level of fear or greed present in the market at a given time. 

I've always used this index as a contrarian indicator. For example, if the index shows a high level of greed, it usually signals a potential market top, suggesting that investors should exercise caution (sell, reduce risk or stop buying). Conversely, a low level of greed in the index might indicate excessive pessimism, potentially presenting buying opportunities.  

Cognitive bias is when an investor exhibits overconfidence, believing they have superior knowledge or skills in picking stocks. If you follow equity markets, you will recall a period during the pandemic where, after the initial fear that the world would collapse, equity markets had a stellar run unlike anything I had ever seen. During this time, (April 2020 to early 2022) the S&P 500 rallied over 100%. You could buy any stock, crypto coin, NFT, house, art, or baseball card and the value would go up.

Everyone felt invincible. In fact, many clients and friends started giving me hot stock tips. I vividly remember a conversation with someone who, with a straight face, told me that her boyfriend was "really good at stocks". Turns out, he wasn't. He was simply being influenced by cognitive bias. This bias can lead investors to make overly optimistic predictions and take on excessive risks. It's not a safe place to be when investing.  

Herd mentality is the tendency of the individual to follow the actions and decisions of the larger group. With investing, it can lead us down some dark paths that end in asset bubbles and market crashes. That's because the investor is not buying the asset because of its underlying fundamentals, and are instead buying it because they are imitating others.  

For example, do you remember NFTs? There was a period of time when I couldn't go anywhere without someone wanting to talk about how NFTs were the future and I must "get involved" (I didn't). This overexuberance for NFTs was caused by herd mentality and it led to an extremely destructive asset bubble burst. 

Whenever I am really upset about something, I call my best friend, tell her the entire story and then wait for her to validate my anger. I call her because I know that she will tell me that I am "right". This is a good example of confirmation bias.

In terms of investing, confirmation bias often looks like this: I love this company XYZ. I buy the stock and then I surround myself with research, articles and conversations about how great XYZ is. When faced with a potential negative view of the stock, I immediately shut it down, don't read it or vehemently try to deny the data that I have been presented with.  

In this example, my confirmation bias has led me to make investment decisions based on a selective interpretation of information that supports my preconceived notion about XYZ. I have overlooked valuable counterarguments, contrary data, and critical perspectives that could provide me with an unbiased analysis of the investment opportunity.

All of these concepts are important to understand when making investment decisions so you can avoid them. Ideally, when you make an investment decision, it is informed, well-researched and risk appropriate. If you find that something feels over-exuberant or frothy, it probably is. Remember that it is best to make investment decisions with a long-term growth horizon so you are less inclined to trade in and out of ideas when they don't show results immediately. Also remember, if someone presents you with something that is too good to be true, it probably is.

Your best defense against letting your emotions lead you to a bad investment is education. CNBC Select has ranked the best brokers for zero-commission trading, and E*TRADE stood out for its extensive educational resources including webinars and dashboards. If you like to invest using a robo-advisor, (which is a more hands-off experience that can help take your emotions out of the equation) Wealthfront offers advice on how to invest for college planning, retirement and more.

Finally, if you are overwhelmed, confused or simply don't feel equipped to make your own investment decisions, you should hire a financial advisor.  

Good luck!  

Kristin 

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