Fear is an emotion that we all experience. But if this powerful feeling comes out when you're investing, it can wreak havoc on your portfolio.
Being afraid of the unknown or that your livelihood is at stake is completely normal. But being aware of the impact fear can have on your portfolio and learning how you can control it can help boost your overall performance in the stock market.
1. It can make you sell low
A stock market crash can be scary. And losing money could actually prevent you from reaching the goals you've saved so hard for. If you have a college tuition fund for your child, plan on buying a house, or dream of retiring next year, a significant hit to your assets could delay those plans. And in an effort to stop these losses, selling your investments during a crash may be tempting.
But this action only ensures that you realize these losses. And if you never reinvest the money again, you can't recoup your money. Even if you buy back in, you may be doing so at a higher price than you sold at, and this could still result in losses or a drastically lower rate of return.
If you held large-cap stocks and sold out of your investments in March 2020 at the bottom, when the stock market plummeted because of COVID-19 fears, you would've realized a 34% loss. But the stock market quickly bounced back, and if you'd held on to your investments, you would've been made whole by July and realized an 18.4% gain for the year 2020.
2. It can paralyze you
Fear can also cause inaction. When this happens, you're not selling or buying at the wrong time. Instead, you're doing absolutely nothing and your cash is left sitting and uninvested -- which has its own disadvantages. When you have money that isn't invested, sure, you can't lose any of it. But you also can't grow it. And participating in the stock market can make meeting your long-term goals a lot easier.
If you have the goal of saving $500,000 for retirement over 30 years, you would need $16,666 in contributions each year. Investing your money could cut that number down drastically. You could achieve this goal by saving $4,100 and earning 8% on average each year over the same time period. Or if you want less risk in exchange for a lower rate of return, $5,000 contributed to an investment account each year and invested at an average rate of return of 7% could get you to $505,365 in 30 years.
How you can keep your fears in check
Your risk-taking ability as an investor is defined in part by your time horizon, and choosing the appropriate investments for your accounts can help keep your fears at bay. Before you invest, you should evaluate when you will need your money. If it's a long time from now, you can potentially choose more risky assets because they will have time to recover in the event of a big loss.
But even then, you may not have the appetite for a bigger risk. It's fun seeing your accounts increase from month to month as the stock market rallies. But if the stock market ups and downs make you panic no matter how much time you have, you may have a lower appetite for risk. In this case, you would benefit from investing a portion of your money in safer investments.
For example, if you only owned large-cap stocks in 2008 during the financial crisis, you would've been 100% invested in stocks and your accounts would've dropped by 37% in a single year. If you only owned bonds during that year, you probably would've felt great because your account would've grown by 5.24%. But over the long term, bonds won't grow your accounts as well as stocks. Finding your perfect mix of the two can help you both avoid losses and achieve long-term growth. And if in that same year, you had a portfolio made up of 50% bonds and 50% stocks, your total losses for the year would've only been 15.88%.
Feeling afraid is OK. But letting that fear control your investment decisions can make meeting your goals harder. Getting to a place where you feel just as comfortable with your losses as your gains is important. And taking a quiz that combines questions about your risk-taking ability and your risk-taking willingness can help you get an optimal asset allocation.