Emotions can sabotage your financial plan and wreak havoc on your investments. Becoming emotional about investing is common and natural. As humans we’re wired for survival instincts. If we see or smell fire we run the other way. Investing often goes against these instincts. If prices drop we think we should sell, but that might not always be the best move in the long term. Below, we’ve outlined the most problematic emotions we see clients face as they determine their investment approach, and how to combat them:
As humans we like holding on to an idea, often the first piece of information we hear, and are resistant to change our view. Psychologists refer to this as “anchoring.” For example, we often see that if investors have been exposed to a bad experience, such as the 2008 financial crisis, they are more averse to investing, as they “anchor” the anxious emotions felt during that time. As financial planners with a long-term view, we work with our clients to remind them that even if you’ve experienced something bad, your goal hasn’t changed. We understand how asset classes move in relation to one other, and put together portfolios strategically so risks are mitigated in the event of market downturns. Our goal is to achieve good risk adjusted returns.
2. Familiarity Bias
We like what we know, and investing is no different. Investors often feel more comfortable buying their company stock or the stock of a local company because it is familiar, so it seems safe. However, making investments solely based on familiarity can lead to a false sense of security. This can result in under-diversification and that puts a portfolio at risk. This is particularly important to remember when buying your employer’s stock. You already have a lot riding on the company since you receive a paycheck from them every two weeks. Imagine you held $100,000 worth of your company’s stock, more than the recommended 10 percent of your portfolio total. You don’t want to sell because it had performed well in the past, and you feel like it is a good company. Ask yourself, “If you received $100,000 in cash today would you go out and buy $100,000 worth of your company stock? Or would you invest someplace else?” This line of thinking often reveals just how much of our holding exists because of “convenience” or the discomfort of having to make a decision.
3. Status Quo Bias
We’ve often heard clients say they “just want to leave things as they are,” and are reluctant to make any changes if their portfolio or a certain stock has performed well in the past. We see this emotion present itself most often when retirement age approaches. Retirees erroneously think they’re protecting their assets by leaving them in their current allocations. However, this emotion can result in undermanaging your accounts. It’s important to continually evaluate what changes can be made to ensure your portfolio is protected and will continue to perform to reach your goals given your actual risk tolerance.
4. Mental Accounting
Let’s suppose you have a portfolio with 10 different holdings and you do well in four and poorly in six. Would you underemphasize the ones that did poorly and put a disproportionate emphasis on the ones that were winners – even if overall the returns were negative? We call this “mental accounting.” As investors we try to encourage clients to keep looking at the big picture by viewing your portfolio as one diversified unit and planning for long-term growth. Being honest with one’s self is the first step. One way to use mental accounting to your advantage is to think of investment accounts as buckets. For instance, if a retired client is relying on distributions every month for living expenses we might have three buckets, each with different growth strategies to meet their short term and long term needs. One bucket might have two years worth of cash or cash equivalents out of which distributions are drawn each month. A second bucket could consist of bonds that could be sold when more cash is needed. The third could be comprised of stocks with a goal of long-term growth to continue to replenish the second and thus the first bucket. With this method, if the market is volatile, clients know they have enough money for their immediate needs and have the ability to wait for a down market to go back up without selling at a loss.
At Legacy we want to take away the financial anxiety so you can better enjoy your life. We will work with you to make sure your risk tolerance and investment strategy work together to achieve your goals, whatever they may be. Contact us today for a complimentary consultation.