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  • Writer's pictureEric Hahn

Don't pay the high costs of emotion-driven market hype

Certainly, by now, any investment enthusiast has encountered an article articulating the dangers of market timing. To be clear, I would construe market timing as an attempt to profit from an investment at a precise moment before the price fluctuates dramatically.

An example would be selling all of your stocks and going to cash. That can be destructive, seeing as the most exalted investors devote their entire careers to developing the acumen needed to know when to step in and out of investments.

Actually, the best investors have a well-thought-out, disciplined investment process and only succeed when sticking to, and making decisions based on, their process.

At our firm, we spend innumerable hours intimately understanding each client's unique circumstances and risk profile before developing an investment road map. And while certainly we tactically manage a risk budget for our more conservative investors, we can confidently say that emotion never plays into the investment process at any point.

Let me delineate this notion using both an index and an individual equity as examples. I believe these distinctly different scenarios pertain to two different types of investors:

The market timer

The investor who attempts to time the market—or index, rather—is most likely guided by emotion. Attempting to time the index fund without a well-thought-out process can lead to dismal returns and loathsome regret. In most cases, it would benefit this type of investor to seek the guidance of an investment advisor.

The reason is simple: One who invests in an index fund almost certainly subscribes to the belief of "modern portfolio theory" (and it is, after all, a theory and not a doctrine, but I digress).

Read MorePostage plus patience can pay off

If investors believe that the proper diversified asset allocation approach is the soundest methodology for their investment needs, then why would they need to abruptly change course? In short, they wouldn't. The decision to sell, I assure you, is driven by emotion and, more specifically, fear.

This is where an advisor can prevent a potentially detrimental deviation from achieving one's financial plan. According to the "Help in Defined Contribution Plans: 2006 Through 2010" report from Aon Hewitt and Financial Engines, those who have an advisor and a plan achieved 2.92 percent net of fees greater annually compared to those who don't have an advisor. If your advisor spares you a single emotional mistake, they've already earned their salt.

Timing stocks

Also common is the attempt to time an individual investment, a stock. This typically relates more to overconfidence—which, it can be argued, is emotionally driven. An individual investor who purchases a stake in a company without having undertaken a deep and thorough understanding of the company's strategic positioning, competitive advantages or valuation is not an investor at all; that type of behavior is more akin to speculation or gambling.

For example, when a company's stock price begins to increase, it's more likely to be boasted about by some person you know who claims to have made a fortune trading stocks in his spare time. (Side note: Beware of this person; if he were really that good at picking stocks, he'd be doing it for a living, because it's a very rare skill and can be a lucrative career opportunity.)

And when you hear about the "easy money" people are making when the market is accelerating, you start to believe that it's simple and that you can also do it simply by picking the right stocks. However, if these decisions are being made without first developing a long-term investment thesis that is sound, then you are playing a dangerous game.

"Unless you have developed the skill set and also have the time to keep those skills sharp ... there are severe costs to making trades based on emotion."

Furthermore, without diligent work standing behind your stock picks, your confidence gets annihilated as soon as your portfolio begins to lose money. Take Warren Buffett, for example. After being asked how to get smarter, he's been quoted as saying: "Read 500 pages … every day. That's how knowledge builds up, like compound interest."

What we see all too often are "investors" who have done little to no research selling their stock as prices go down and waiting to buy again only after the price, and their false sense of confidence, has already appreciated. This behavior will most assuredly erode investment returns.

Regardless of your individual circumstances, a trusted financial advisor believes the solution to any problem is to make a plan, develop a thesis, or set a goal—and to stick to it. Whether it involves meeting with an advisor or building a treehouse, you should start with formulating a sound plan of action.

I personally believe that unless you have developed the skill set and also have the time to keep those skills sharp—whether you're a fan of market indexing or attracted to investing in individual companies—there are severe costs to making trades based on emotion.

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