In 2013, I attended a conference at Duke University on Behavioral Finance; the course emphasized how we as human beings are prone to invest emotionally. When the markets are doing well, we feel good about our portfolio and want to invest more. When the markets are not doing well, we want to sell what we have and “wait until it hits a bottom.” Unfortunately, no one knows when the bottom is going to happen. In fact, it’s so well known that there’s a very old saying, “nobody rings a bell” that dates to around 1900.
“Nobody rings a bell at the top or the bottom of a market” (Wall Street proverb) The New York Stock Exchange opens to the sound of a bell and then closes to the sound of a bell. It’s often pointed out that no one rings a bell to announce the top or the bottom of a market, however. The Wall Street proverb appears to date back to around 1900. The proverb, like the bell, is still in use today.)
Having been in this business for close to 50 years, I’ve seen many bull markets, and many bear markets. Every time, it feels permanent like, “it’s different this time.” When we’re in the middle of a bear market, our emotions fear that this time it’s not going to turn around. The conditions are so terrible, how could it? 911. War. Inflation. Deflation. Presidential elections. Politics. Mass murders. Riots.
Dr. Dan Ariely heads up The Center for Advanced Hindsight at Duke University; he was the instructor for our course. (If you get a minute, he has numerous YouTubes -he’s very entertaining.). He encouraged us to come back to our offices and have clients sign a letter to themselves that basically says:
Dear Future Self,
Today is ______ date, and my portfolio is worth $_______.
The value of your portfolio is going to drop. You’re not going to like it. It’s going to make you uncomfortable. You might be tempted to call your financial advisor and switch to a more conservative asset allocation – i.e. less risk.
Hold the phone, future self.
Remember that you’re in this for the long term. There are going to be ups and downs. If you jump in and out of the market during the downswings, you risk missing out on longer-term growth opportunities.
Future self, consider the following: from 1993 to 2023, the stock market as measured by the S&P 500 index grew at 9.97 % per year on average. Investors during this period earned an average annual total return of just ___%. Why? It’s likely investors jumped in and out of the market. Don’t be that investor.
Think back, Future Self, to when you originally invested. You told yourself that you would be OK with a certain amount of volatility. If you’re reading this letter now, said volatility has arrived. STAY THE COURSE.
All the best,
Current Self’s Signature
The information that follows is specifically about Emotional Investing and Cognitive Biases. Read on:
Investing is often considered an analytical pursuit driven solely by numbers and financial data. However, it is far more than a mere numbers game. It involves an intricate interplay between human instinct and the ever-changing dynamics of the market.
Fear stands out as one of the most potent and influential among the vast array of emotions that can influence investment decisions. It can cloud judgment, skew perception, and drive investors to make choices that may not align with their long-term goals.
Despite its pervasive influence, people must recognize the impact of fear to mitigate its negative effects. This article will explore how emotions can impact investment mentality, and it will equip even the most seasoned investors with the knowledge to balance rational analysis and emotional awareness.
Rational vs. Emotion-Driven Decision-Making
The two contrasting approaches to investment decisions are rational and emotional decision-making. While both have merits and drawbacks, understanding their distinctions is crucial for investors to navigate the financial market effectively.
Rational decision-making relies on a systematic and analytical approach. It involves gathering relevant information, conducting thorough research, and evaluating the risks and rewards associated with an investment. Rational investors typically aim to maximize returns and minimize risks by leveraging facts, figures, and objective analysis.
On the other hand, emotional decision-making is heavily influenced by feelings, instincts, and gut reactions. Emotion-driven investors rely on their intuition, personal biases, and subjective interpretations of market conditions. Fear, greed, and excitement can greatly impact their investment choices.
The Fear Factors in Investment
Fear can paralyze investors, increase market volatility, and intensify irrational behavior. It can also cause impulsive behavior and cognitive biases that impair rational decision-making. Understanding the fear factor and its impact is critical to keep a long-term perspective and make informed decisions.
Here are four of the most common fears of investors:
Fear of Loss
The fear of loss is an instinctive response to the possibility of losing one’s hard-earned money or experiencing a decline in investment value. It can profoundly influence people’s behavior and mindset, heightening caution, and risk aversion. This fear also often manifests as a strong desire to preserve wealth, sometimes at the expense of potential gains.
Fear of Missing Out
Fear of missing out (FOMO) is a strong desire to engage in opportunity others are taking advantage of because of concerns about being left behind. It frequently occurs when investors identify a fast-rising or popular investment opportunity in financial markets.
Fear of Market Volatility
The fear of market volatility is the apprehension investors feel in response to sudden and significant financial market fluctuations. People may worry about the potential negative impact of these movements on their investments and overall portfolio value. This often leads to extreme caution and risk aversion.
Fear of Inflation
Fear of inflation is a common issue among both investors and consumers. It refers to the anxiety associated with rising costs of goods and services over time, reducing money’s purchasing power. People may be concerned that their savings and investments may not keep up, reducing their ability to accomplish future financial goals.
Other Emotional Biases and Cognitive Pitfalls
It is important to recognize that several other emotional biases and cognitive pitfalls can impact investment mentality. These can also cloud investors’ judgment, lead to irrational decision-making, and hinder their ability to achieve optimal investment outcomes. Below are a few examples:
Confirmation bias refers to the tendency to seek, interpret, and remember information in a way that confirms preexisting beliefs. This leads to investors downplaying contradictory evidence and reinforcing preconceptions, which creates an echo chamber effect.
Loss aversion relates to people’s preference for avoiding losses over earning equivalent rewards. In other words, people are more sensitive to potential losses than probable gains of the same amount. Due to this, investors may be hesitant to sell lost investments even when it is advantageous.
Herding behavior occurs when investors make decisions based on the actions and opinions of others rather than conducting their own research. While it can sometimes result in short-term gains, it also poses risks. If the herd is driven by irrational or uninformed decision-making, it can lead to significant losses when the market corrects itself.
Overconfidence leads people to overestimate their skills, underestimate risks, and have an inflated sense of their ability to predict outcomes accurately. One example is the illusion of control, where investors believe they have more control over results than they do. This can lead to excessive trading, market timing attempts, or concentrated investments in a few high-risk assets.
Actionable Strategies for Emotionally Intelligent Investment Planning
Investors can develop strategies that enhance their performance by recognizing and harnessing the power of emotions. Here are some of the most practical tips for emotionally intelligent investment planning:
1. Setting Clear Investment Goals and Objectives
Investors must define the specific outcomes and targets they aim to achieve through their activities. Clear goals provide direction, focus, and a framework for making decisions that align with one’s financial aspirations and risk tolerance.
2. Practicing Disciplined Decision-Making
Responsible decision-making involves adopting a structured approach while managing impulsive behavior or emotional biases. By staying disciplined, investors can make more rational, informed, and strategic choices.
3. Seeking Professional Guidance and Advice
A financial advisor can help investors enhance their strategy and overall economic standing. They can also provide personalized advice and tailored solutions based on the investor’s unique financial goals, circumstances, and risk tolerance.
4. Staying Informed To Reduce Fear-Based Decisions
Keeping up to date on market dynamics and trends allows investors to identify short-term volatility and long-term fundamentals. It helps them recognize that fluctuations are a natural part of investing and that staying on the course may be the best approach.
Gain the Competitive Edge in Investment Planning!
Integrating rational observations with emotionally intelligent analysis allows individuals to make well-informed and well-rounded decisions. This comprehensive approach can help navigate the complexities of the financial markets with greater clarity and preparedness.
Working with Hudock Capital’s financial advisor can provide peace of mind and alleviate the stress of making complex decisions. This allows investors to focus on other important aspects of their lives while knowing that their financial well-being is in capable hands. Contact us today for wealth management services.