When it comes to your finances, emotions have their place. After all, if you never worried about the future, you would probably never buy life insurance, put money away for retirement or save for your children's college education.

More often than not, however, emotions can get in the way of sound financial decisions. It is human nature to become greedy during good times and to panic during bad times. Because you cannot turn off your emotions, try to understand how they can undermine your investment decision making. Then, focus on setting limits that will enable you to invest successfully.

No One is Immune

Emotions can make the key to successful investing — buying low and selling high — especially difficult to pull off. Too often, they can lead investors to sell precisely when they should buy, and buy when they should sell. Investors, generally, are wired to maximize gains and avoid losses. So when stocks are on a winning streak, they may conclude the good times will never end. This can blind them to the risks of buying, say, a high-flying biotechnology stock just before it returns to earth.

Similarly, when financial markets are collapsing, the temptation is to sell as quickly as possible, perhaps shifting into investments such as cash or U.S. Treasuries just at the low point of the market, and missing out on the recovery.

It is not just novice investors who are vulnerable. Even the most sophisticated market participants are at risk, according to recent research from David Tuckett and Richard Taffler, authors of Fund Management: An Emotional Finance Perspective. This 2012 study, based on interviews with more than 50 portfolio managers, concludes that even professionals are prone to fall in love with their favorite stocks — attitudes that can prevent them from making rational judgments about appropriate times to buy and sell.

Strategies for Long-Term Results

Understanding the harm your emotions can inflict on your portfolio is half the battle. The other half is to put a process in place that can help you invest unemotionally. Here are some strategies to consider:

  • Create a Plan (and Follow it) — Your advisor can help you develop an appropriate financial plan. Every investment decision you make should be consistent with this approach. By having specific goals and a strategy in place to achieve them, you will find it easier to be dispassionate about your choices.
  • Put Your Portfolio on Autopilot — Setting up your investments to occur on a regular schedule — for example, monthly or quarterly — takes the timing out of your hands.
  • Maintain a Diversified Portfolio — It may be the oldest cliché in investing, but not having all your eggs in one basket is an effective defense against reacting unproductively to volatile financial markets. By maintaining a broadly diversified portfolio with different types of relatively uncorrelated investments, you will be less likely to panic when conditions are challenging.

The Cost of Following Your Emotions

Somewhere in nearly every communication you receive from your mutual fund company, you will see this line: "Past performance does not guarantee future results." Too often, however, we ignore this time-tested wisdom when making investment decisions.

Financial research company Morningstar has compared mutual funds' reported returns with the actual returns received by investors, with the difference reflecting buying and selling activity during the holding period. According to Morningstar's data, the average U.S. stock fund investor lost a full percentage point of performance during the 10-year period ending Dec. 31, 2012. For investors in international stock funds, the story was even worse — investors cost themselves more than three percentage points of returns. This was true for average and professional investors alike.

In fact, it is extraordinarily difficult to know the optimal time to buy and sell stocks. Market signals create the temptation to chase past performance by buying high-priced investments, while ignoring potential bargains with subpar results but better future appreciation prospects.

Know the Signs

Making decisions based on fear, greed and other gut instincts typically is a recipe for subpar performance.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.