We all love to see quick results. Whether it’s career progress, a workout plan, or an investment portfolio, it’s exciting to see fast results. And it can be frustrating when progress doesn’t come quickly: when you’re not learning those guitar chords fast enough or your portfolio isn’t shooting ahead of the Dow.
Achieving real progress and real gains usually takes time in spite of tantalizing offers to get rock-solid abs in seven days, learn to flip houses in two weeks, or a discover sure-fire stock that’s the next Apple.
It’s human nature to crave quick results but when it comes to investing, your emotions – or a desire for quick gratification – can get in your way of building a solid financial plan. (For more about Behavioral Finance, see: 8 Common Biases That Impact Investment Decisions.)
In a recent article for The Motley Fool, columnist Morgan Housel made some excellent points about how we limit our chances of seeing real progress by letting our emotions get the best of us.
“Most investing mistakes and frustrations come from trying to run a marathon in an hour,” Housel writes about the difference between short and long-term investing. “Companies earn profits, and over a long period of time those profits accrue to shareholders. If you leave it at that – and you should – investing is such a basic game that doesn’t require much action.” (For more, see Why Investors Can Be Their Own Worst Enemy.)
If we stuck to that game plan and utilized a long investment horizon to really take advantage of compound interest, the progress you would see would be impossible to ignore. Compound interest is a great way to look back and see the progress of your investments over a long time horizon. We summarize it like this:
Compound interest is often compared to a snowball. If a two-inch snowball starts rolling, it picks up more snow, enough to cover its tiny circumference. As it keeps rolling, its surface grows, so it picks up more snow with each revolution. If you invest $1,000 in a fund that pays 8% annual interest compounded yearly, in 10 years you’ll have $2,158.93, in 20 years that will be $4,660.96, in 30 years it will be $10,062.66, and in 40 years it will be $21,724.52. All it takes is patience to turn $1,000 – the price of one ski weekend – into $21,724.52.
A main problem many investors have is they fail to allow for this long time-horizon to play out. Housel’s next point builds on this when he says…
“Progress happens too slowly to notice; setbacks happen too quickly to ignore.” This ties into the idea of prospect theory and Housel summarizes this concept well: “Pain hurts more than the same level of gain feels good.” This is similar to the concept of loss aversion where investors make emotional decisions that unfortunately lead to doing the exact opposite that one should do. Take 2008, for example, when the markets lost almost 40% in a short period of time. Those who made emotional decisions and exited the markets quickly not only locked in a significant loss but likely missed out on one of the biggest bull markets in history as the market tripled over the next six years.
So much of this is human psychology. Having a dollar that stays a dollar doesn’t feel like you’re losing money. And losing a dollar often hurts more than gaining a dollar feels good. It’s like sports — losing a close game generally makes people feel lower than winning a close game makes you feel good. That’s what makes our job so interesting — working with people to park their psychology at the door, not just today, but forever. Not easy, but when done correctly you can really start seeing that elusive “progress” word come into play. (For more, see: Why Playing It Safe Could Hurt Your Retirement.)
“Most investing success boils down to avoiding catastrophic mistakes.” You don’t need to be the world’s greatest stock picker to benefit from investing. Far from it actually. As Housel puts it: “Few good decisions are needed to do well over time.” Instead, what we need to do is avoid making the catastrophic mistakes that typically come from making an emotional decision and not planning properly. Market corrections happen. They will happen again. Without proper planning, it is easy to fall victim to the pitfalls of prospect theory and end up making an emotional, short-term decision that can derail any progress that you have made.
To summarize, all of this boils down to a simple line of thinking. When it comes to investing, leave your emotions at the door. If you are uncomfortable with your investments, that is something you should take immediate action in. You may be invested in a portfolio that is too risky based on your goals, risk tolerance and needs. You may just not fully understand how you are invested which makes you nervous. Worst of all, you may have no plan what so ever. Start by reevaluating your goals, short, mid and long term. Create a plan and road map to accomplish those goals, and then stick to it. (For more, see: Which Investor Personality Best Describes You?)
This article was originally published on Investopedia.com
Also published on Medium.