A lot of people consider themselves emotional investors. They buy stocks because they're fans of the companies behind them, and they're tempted to sell stocks when market conditions take a turn for the worse.
Being an emotional investor could have a negative impact on your portfolio, though. For one thing, it might drive you to make rash decisions that lead to losses -- such as selling off stocks during a market crash.
Also, while investing in companies whose businesses you know and understand is actually a good thing, there are other considerations that should go into your investing decisions. These include how well those companies are doing financially, what their management teams look like, and what risks and opportunities they face in the coming years.
If you've been known to let emotions dictate your investment choices, here are a few ways to avoid getting hurt in the process.
1. Know how to vet a stock
Whether you're a fan of a company or not shouldn't really matter when it comes to investing. You might shop often at a given retailer, but if its sales numbers have been on a steady decline and its outlook is poor, that's not a stock to add to your portfolio.
Aim to familiarize yourself with some of the different metrics you can use to research a stock from a financial standpoint. These include:
- Net income
- Earnings per share (which measures profitability on a per-share basis)
- P/E ratio (which takes a stock prices and divides it by earnings per share)
2. Commit to an investing pattern
Many investors have success with a system known as dollar-cost averaging. With dollar-cost averaging, you commit to investing a certain amount of money at preset intervals, regardless of what stock values look like at that time.
You might, for example, decide to put $200 a month into a specific S&P 500 index fund, whether its value is up or down. Or, you might choose to buy $200 worth of a specific company, regardless of what its most recent earnings report looked like.
The whole point of dollar-cost averaging is to take emotions out of the equation. And often, if you stick to that system, you'll end up paying less per share than you would by trying to time the market.
3. Shore up your emergency fund
When your portfolio value starts to decline, you might panic and sell off stocks before things get worse. After all, what if you need that money in a pinch? If so, you can't afford to let your balance continue to drop. But if you make a point to sock away a separate pile of cash in a savings account for emergencies, you may not need to give in to fear as much.
Ideally, you should have enough cash outside of your investments to cover a minimum of three months' worth of bills. For better protection, aim for six months' worth.
4. Don't invest money you might need soon
As a general rule, it's a good idea to only invest money in stocks that you don't expect to need for seven years or longer. The logic there is that you'll have plenty of opportunities to recover from market downturns during that long a window. This means that if you're hoping to buy a home in three or four years, you shouldn't put your down payment into stocks and hope for the best.
Some people are wired to be more emotional than others. But when it comes to selling and buying stocks, that could hurt you. If you tend to be an emotional investor, aim to adopt these tips to grow your wealth steadily without getting hurt financially.