If you make your investment decisions based on emotion, chances are high that you will make poor choices.
Replacing emotional decisions with logical decisions is easier said than done, especially when your money is at risk. It's a classic head versus heart thought process. Understanding your goals and objectives as well as your tolerance for risk is logical. Choosing your investments based on what you see on cable TV's financial news or an Internet message board is not.
Many studies have shown that investors often undermine a sensible investment strategy by getting caught up in market hype, overacting to news or believing every word of a self-proclaimed investment guru. Usually if it sounds too good to be true, it's probably not true. Making quick investment decisions based on limited information and resources are emotional decisions. The more time and research you devote to those decisions, the more you reduce the chance that emotion is the justification behind them.
A logical investment strategy would certainly include diversification. Logical diversification includes investing in multiple asset classes such as equities, bonds, cash, commodities and real estate. And further diversifying inside those asset classes by sector, market capitalization, credit quality, maturities, foreign and domestic, value and growth, senior and emerging, etc, etc. Paying close attention to your investment diversification should reduce the measurement of risk in your overall portfolio. And also help keep your emotions in check.
Diversification does not guarantee profit or protect against loss in declining markets.
As you diversify you will want to be aware of several different performance measurements. It's easy to be cognizant of the most obvious measurement; it's called the return on your invested assets. But other numbers must also be paid attention to. The volatility measure we most commonly use is standard deviation. If you will remember your old high school statistics class, standard deviation is the measurement from the mean to the positive and negative extreme. The higher the standard deviation in an investment portfolio typically means higher risk.
A really helpful performance measurement of an investment portfolio is called a Sharpe ratio. Developed by Nobel Laureate Dr. William F. Sharpe to measure risk adjusted performance. I won't bore you with the calculation for a Sharpe Ratio, but the result tells you how much return you are getting for every measurement of risk or standard deviation. The higher the Sharpe Ration means the more risk efficient your portfolio is.
One of my mentors is a gentleman I have never met. His name is Dr. Harry Markowitz, who won the Nobel Memorial Prize in Economic Sciences for his work in Modern Portfolio Theory. His conclusion that earned his Nobel Prize was that if two portfolios had the same expected return, the lowest volatility portfolio would out perform the other. Ultimately your investment success will depend on not just the returns on your invested assets, but also the volatility of those returns.
If your current investment strategy causes you to be euphoric one moment and desperate the next, you may want to consider a change. Think of it as Prozac for your investments.
The key here is to diversify your investments and attempt to reduce the volatility of your portfolio, and monitor your portfolio performance measurements. If you do this, it's my belief that your days as an emotional investor could be reduced.
• William J. Hertzog, CIMA, is first vice president of investments for Wells Fargo Advisors, LLC, in Ahwatukee. Reach him at (602) 952-5133 or www.TheHertzogGroup.com. Wells Fargo Advisors, LLC, member SIPC, is a registered broker-dealer and a separate non-bank affiliate of Wells Fargo & Company. Note: Investment and insurance products are not FDIC insured, not bank guaranteed and may lose value.