Reacting emotionally can cost you financially and affect how you'll invest in the future. The key is to stay calm when markets get bumpy and avoid the mistakes others will make.

Why emotion and investing don't mix

Throughout history markets have followed a natural cycle. Optimism drives asset prices a step too far leading to an inevitable decline. We can see this in the historical performance of the S&P/TSX Composite Index (and its predecessors) going back decades. Based on its annual pattern, expect a negative market on average about once every four years followed by a return to growth.

When markets are running strong we're confident to take on risk in search of a greater return. But when prices sag our enthusiasm quickly disappears. Instead of accepting occasional declines as a normal part of investing, we often get scared. If things get bad enough we'll sell out – likely at a bottom.

Renowned financial research firm, Dalbar, has tracked the long-term behaviour of mutual fund* buyers in the U.S. and found psychology, not just economics is at work when it comes to investment performance. The research shows the average investor underperforms market indexes by a wide margin; a difference so large it can't be explained by fees alone.

Over the last 20 years, the average equity fund investor earned less than 4% annually. At the same time the market (S&P 500) produced an average gain of over 9%. And it isn't just stock* investors who fell short. Fixed income investors barely squeaked out a 1% annual return compared to a 7% average rise in the index.

Market losses can make you more cautious in how you approach investing, and this can steer you toward investments that are too conservative. For most people taking on some risk is critical to generating enough growth to achieve goals and protect wealth from inflation.

How can you take emotion out of investing and stay on the path to achieving the results you want?

Tune out the noise

Even if you're not the worrying type, there are times when it's almost impossible to ignore the mood of the market. Between around-the-clock business news, smart phones and social media, never before has the average investor had access to so much information so easily.

While you might think experiencing the world in real time can make you a better investor, if you're not careful the opposite will happen. Here's why.

Typically, the more volatile things get the more you'll watch the markets, mistakenly thinking you'll be able to spot major trouble just before it happens. The more you watch, the more anxious you become. While all that watching won't change anything, it will increase the odds you'll overreact to the headlines and make a rash decision with your investments.

Try a more balanced approach. Be aware of what's going on, but resist the temptation to over-monitor your portfolio. If you ignore the headlines and daily twists and turns of the market you'll be better able to keep emotion in check and stay focused on what matters most – your goals.

Evaluate and rebalance

If you're a long-term investor "buy-and-hold" can easily turn into "buy-and-forget". The current market volatility offers a good opportunity to stand back, take a look at your portfolio, and decide if any changes need to be made.

If you worked with your advisor to establish an asset mix of stocks, bonds and cash suited to your risk tolerance and objectives, now's the time to compare your portfolio against that target.

Stocks have had a strong run since the lows of March 2009. Has that left you overweighted in equities and underweighted in bonds and cash? If so, consider locking in profits by shifting some of your investments out of equities and into other asset classes to restore your ideal mix. Not only does this process help you "sell high" and "buy low", but it keeps your portfolio's risk in check.

While no one likes to lose money, there may be times when selling at a loss makes sense. An investment might have little chance of regaining its value or perhaps it no longer fits your plans. Holding on means you tie up valuable cash that can be put to work elsewhere. You also create tax benefits when you sell.

Use losses to first offset any capital gains you incur from rebalancing your portfolio. This will reduce taxes you might otherwise have to pay. Afterward, if you still have losses you haven't claimed, you can apply these against future gains or carry them back up to three years.

Learn from history

It's challenging to keep your nerve when the market drops suddenly, taking your portfolio with it. But history teaches the dark days eventually end and markets resume their advance.

Unfortunately this lesson can be hard to recall when you need to remember it most. People tend to think each downturn they're experiencing is "different" and somehow worse than anything they've gone through in the past.

But rebounding from a crisis is something financial markets do well.

Think about what we've seen in the last 25 years: the 1987 "Black Monday" crash, two Iraq wars, the Asian currency crisis, the bursting of the tech bubble and the 9/11 terrorist attacks. Not to mention a couple of recessions sprinkled in between.

In every case the global economy didn't end. Broad market indexes recovered – often quickly – and went on to new highs. Earlier this year the S&P 500 reclaimed all the value that was lost in the recent financial crisis, and did so in less than two and a half years.

The Comeback Kid: How long it took the S&P/TSX Composite Index to recover after a market shock

Here's an example of how "sticking it out" can pay off. Say you invested in the S&P/TSX Composite Index at the start of 1985. Through difficult world events, recessions and bear markets your investment would have grown more than ten-fold in value (with dividends reinvested) by the end of last year. That's more than a 9.5% compound annual rate of return, far outpacing inflation.

Don't try to time the market

Here's the trouble with "market timing", the sell now-buy later strategy. It means getting two calls right. First, you have to correctly guess when to get out of the market. Then, you have to decide when to get back in; ideally at the bottom. Wait too long and you can miss out on the market's recovery, leaving you worse off than if you had just stayed the course. Plus, if you sell out, you'll likely interrupt whatever investment plan you put in place before giving it time to work.

The reality is that no one, not even professional investors and money managers, can accurately predict when to get out and back into a market. Rather than market timing, history teaches us it's time in the market that counts.

Equities rise, but when they do it's rarely at a steady pace. Stocks can move sharply higher in just a few days or weeks and then flatten out for much longer. If you happen to miss out on the market's best days it can seriously impact your returns. This is the risk market timers face.

Let's take an example that shows just how costly being out of stocks at the wrong time can be. Suppose you had put $10,000 in the Canadian market in August 2002. Fidelity Investments Canada calculated that by the end of 2010 your investment would have more than doubled to $25,131. But if you had missed out on the ten best trading days during this period your investment would have grown to a mere $13,687.

Resist the temptation to time the market and instead just stay invested, through the good times and the bad.

Dollar-cost averaging: invest regularly through thick and thin

Volatile markets could occur more frequently in the future than they have in the past. In our increasingly connected, globalized world, investment capital can quickly shift from region to region and bounce between asset classes. Speculators drive short-term market movements and commodity prices sway to the fortunes of emerging economies.

Having a regular investment plan can let you take advantage of the ups and downs while helping you keep your emotions in check. The discipline of putting a fixed amount into the market at regular intervals lets you buy less when assets are pricey and more when they're cheap.

This process of dollar-cost averaging turns volatility from foe to friend. And if you stick to a regular investment program you're less likely to put all your money into what might turn out to be a market top.

Emotions of fear and greed can take financial markets too high on the way up (bubble) and too low on the way down (crash). When a herd mentality emerges it's tough to move in the opposite direction. We might feel safety in numbers, but the crowd's often wrong. In a volatile market your emotions will be hard to resist and it can be difficult to know what to do next.

Regardless of what's happening around you, remember you're an individual with unique goals, lifestyle and income needs. An investment professional can help you make sense of it all. They'll review your situation objectively and can help build a strategy that not only meets your long-term financial goals, but one you can stick to through changing markets. And when important events happen, they can help you adjust and execute your plan.