Our recent pandemic-induced market correction created high levels of uncertainty for many investors. As market volatility peaked, some individuals made excellent financial decisions and invested more money, while others made reactive investment decisions – selling investments in an attempt to cut losses – a move that causes more harm than good in supporting their long-term financial plan.
Behavioral finance examines the ways emotions impact financial decisions and how stress leads to financial self-sabotage. The application of behavioral finance includes activities such as spending, investing, trading, financial planning, portfolio management and business commerce.
Emotion is a driving force for many of these activities. And, unfortunately, this includes the way individuals respond to fluctuations in the market. Responses generally include over-spending or investing at times of excitement and adopting an “abandon ship” mentality when things are low.
The good news: there are several ways one can work to avoid these reactions. By limiting the sources of emotional extremes and obtaining a better understanding of market history, investors can better maintain their footing during times of market instability.
How to Avoid Emotional Investment Decisions
Understand Your Risk Tolerance. Risk tolerance is your ability to tolerate the potential risk of a financial decision, typically an investment. In other words, if the market takes a turn for the worse, your overall livelihood would not be at risk. This does not mean your investment will be lost, it could be the exact opposite. Rather, risk tolerance seeks to counteract the stress of investing and spending, reducing the likelihood that individuals will withdraw their investment during difficult times or overspend during exciting times.
Limit Investment Discussion. Friends, family, articles and the news will all discuss the conditions of the market. But as a savvy investor, you can reduce emotional turmoil by limiting how often you engage in these interactions. This is not to say that you should not be informed. Rather, it is to avoid the immediate emotional responses that often lead to poor financial decisions as a result of reactionary media coverage and discussions with friends and family.
Establish Portfolio Diversity. Similar to risk tolerance, a diverse portfolio seeks to reduce the stress of investing by not placing all of your eggs in one basket. Instead, growth in one area can offset a setback in another, preventing the dramatic drops in portfolio value that often create the stress or excitement that leads to poor financial decisions.
Understand Market Trends. Understanding a problem can often reduce the anxiety around it. This approach applies to investing as well. For example, markets are cyclical in nature. Looking at a trend of the U.S. market may help investors better understand this. The wave pattern we see in market trends tells us that whenever there has been a rise in the market, it eventually was followed by a drop and vice versa. What varies is the duration of these peaks and valleys. It’s important to remember, however, that past performance is never a guarantee or indicator for future performance.
Even if you do lose money on an investment, your financial advisor may advise you to stay in the market to make up for those losses – meaning that while your first instinct may be to pull out, your financial partner sees the long-term benefit of staying put. As an example, you could very well regret selling when the market is lowest, only to miss the expected climb. Being aware of trends can help reduce the emotional extremes of market fluctuations by understanding that successful investing means focusing on long-term goals, not short-term peaks and valleys.
An awareness of the impact of your emotional state on decision making can help avoid potentially harmful reactions that impact your financial wellbeing. When next examining your portfolio, consider the above tips to help you maintain a more stable footing.
As always, it is Charter Oak’s pleasure to serve as your trusted financial partner and we wish you and your loved ones a very happy Valentine’s Day weekend. It is always a good time to celebrate our love for each other, and this year is certainly no exception.
P.S. If you did not receive your stimulus payments (and were eligible to do so), then you may be able to deduct them from your 2020 taxes through an IRS Recovery Rebate Credit. See this IRS web site for more information.