Behavioral Finance
How Emotions Can Lower Your Investment Returns
With the stock markets at historic highs and the political landscape radically different than any of us have seen, I have been getting a lot of questions about what to do with people’s investment and retirement accounts.
To say we are living in interesting times might just be an understatement. The longest bull market (for the S&P 500) in history ran from 12/4/1987 to 3/24/2000. That is 4,494 days! Our current bull stock market is the second longest on record, which began on March 9th, 2009, being in its 3,286th day as of March 7th, 2018.* So, we have a ways to go to beat the current record, but people are still getting nervous and asking me a lot of questions.
My clients have been asking questions like;
- What do I think about the markets?
- How will the new political landscape affect the markets?
- Should they reduce risk in their investment and retirement accounts?
- Are they on track for retirement?
Unfortunately, my crystal ball has never seemed to work! So, my conversations with clients have been about the time-tested fundamentals of investing, planning for the future, and what these mean for their unique situations. Things like asset allocation, diversification, and having a financial plan are time-tested strategies that can have a significant impact on your financial situation
► According to an article by Forbes people who seek professional advice gain an ‘advice advantage’. “On average, those who take advice and have financial plans have amassed over 3.5 times (375%) the retirement assets and over 5 times (518%) the non-retirement assets of those who do neither. Combining planning and advice yields the best results.”**
Think of a financial adviser as your coach or guide, teaching you valuable information while also helping you stay the course during the more stressful & volatile times.
Emotional Investor?
So how do your emotions get in the way of these fundamentals and why does that lower your return?
Let’s start with traditional financial theory. It suggests that we, as investors, are always rational and seek to maximize our wealth through an objective and non-emotional investment decision-making process. This makes total sense from a logical point of view. Who invests with the plan to lose money? Yet, this is where we start to have some problems. Fear and greed are primal emotions we all have. Couple them with speculative hysteria (herd instinct) and he has the potential for our investments to get off track.
If we invest our money in a vacuum, one where we are oblivious to the outside world and all the noise about what could go wrong, emotions would not be a problem for investing. We learn the fundamentals of investing, figure out where we need our investments to be at a point in the future, and then wait till we hit our objectives, reviewing our progress along the way.
The problem with this is that we do not live in a vacuum. It has been my experience as a certified financial planner® that people get nervous about the “markets” because of what they heard on TV, the radio, a podcast, or even from one of their coworkers at the communal water cooler. We are bombarded with these types of information, most of them just sound bites that the media uses for ratings. This affects our emotions, a lot!
The following graphic shows the rollercoaster ride of an investor as the markets do what they do. I am sure we can all relate to these different stages, but seeing how they fit together tells a much more helpful story than looking at each stage by itself.
So how do our emotions affect our investment performance? Whether we like it or not, our emotions can lead us to make irrational decisions, based more on how we are feeling than facts. It simply is a way of life, part of how we are wired at our core, and it can affect a wide variety of aspects of our lives. The following graphic illustrates how our emotions can lead to bad decisions for our investments and the long-lasting effects of those decisions.
The takeaway from this example is that Mrs. Steadfast had a plan and stuck to it, not getting distracted by all the noise out there, thus keeping her emotions in check. Does this mean the rollercoaster ride isn’t scary at times, making you want to lose your lunch? Of course not, this is normal! But we don’t get off a rollercoaster ride as we are going upside down, do we? It is common sense, and safe, to stay the course and wait for the ride to finish. As the example above shows, doing the same thing with your investments can make all the difference.
Risk Management
If you are worried about your investments, retirement, cash flow, etc. then you should probably take a step back, breathe, and look at how you are invested for the long term. If the market does crash, how could it affect you? What impact would it have on your future, especially retirement?
One of the things I help my clients with is answering these questions. We look at their entire financial plan and model how market downturns could affect their future. Being able to see how market conditions today could affect your financial future has been a huge relief to my clients because they can see that they are ok and don’t need to worry, or that we should discuss alternative options that may better suit their financial situation. Either way, the communication and analysis help smooth out all those ups and downs of the rollercoaster.
This leads to less emotional investment.
Education and information is key to all of this. The more you know about the fundamentals and how your particular financial situation is structured the better prepared you are to make sound decisions based on strong information. There is no guarantee when investing, but being armed with these principles can give you a much smoother ride than just winging it!
Best Regards,
Derek Notman
