How Your Emotions Can Reduce Your Investment Returns

Building a solid, diversified portfolio of investments is a big part of retirement planning. But there’s another key step you need to master: controlling your emotions.

A recent report by Morningstar provides clear evidence that too often investors buy and sell shares of mutual funds and exchange-traded funds (ETFs), thinking it will boost their returns when it, in fact, ends up reducing their returns. The net takeaway from the Morningstar research is that being a buy-and-hold investor can be a smarter strategy.

Here's what Morningstar found: For the 10 years through 2024, the average annual return for all the mutual funds and ETFs in its database was 8.2%. But the average return for investors in those funds was 7%. This return was “asset-weighted,” meaning it reflects the actual dollar amount investors had in specific funds and ETFs.

The 1.2 percentage point difference between the market return for those funds and the average asset-weighted return investors pocketed is the result of mistimed trading. Investors earned less on average because they bought more shares ahead of stocks falling and sold more shares ahead of stocks rebounding.

In other words, we seem to be victims of our emotions. When we see stocks going up, we get excited and optimistic that they will just keep going up. Or we develop a fear of missing out when we see the headlines or hear friends boast of market gains.  So we buy more shares. Or when stocks are falling and we see our account values dropping, we get nervous and sell shares because we think the bad times will just continue.

And that emotion-filled trading tends not to work out. To the tune of a 1.2 percentage point lower return over the past 10 years.

And that is a significant difference. Let’s say you invested $10,000 and left it untouched for 10 years through 2024, during which it grew at an annualized 8.2%. After 10 years, your account would be worth around $22,000. If you then just left that growing for another 30 years, and we assume the same 8.2% annualized return, you would have more than $230,000.

Now, let’s say that your $10,000 investment grows at 7% annualized. In 10 years, it will be worth less than $20,000, and after 40 years, it will be worth about $150,000.

You invested the same $10,000, but there’s an $80,000 difference in what you could end up with over 40 years based on being a less emotional, patient investor.

I want to be clear: I am not advocating that you can just set your portfolio and forget about it. We all need to be engaged custodians of our retirement security. That means having an asset allocation strategy (how much in stocks, bonds, and cash; how much in U.S. vs. International stocks, etc.) and then checking your portfolio at least once a year to make sure it still reflects your goals. Over time, you will also likely want to change your asset allocation strategy: as retirement nears, you may want to reduce your overall investment in stocks. Notice I said, reduce. I did not say eliminate.

If you do want to be an active trader, I would recommend doing that with a smaller portion of your investment money. And be sure that whenever you are about to buy or sell shares, you check if you are letting your emotions drive the decision. Trading can only be successful when it is based on a well-reasoned investment theory or insight.