When it comes to investing our hard-earned savings, it’s difficult to remove emotion from our decision making, especially as those savings fluctuate up and down with the market. For most people these assets are grown over decades through saving and hard work – how could we not be emotionally attached? Especially when considering retirement assets, a portfolio can feel like a member of the family; they’ve seen the good times and the bad, from the job we loved to the one we didn’t, from our youngest child’s wedding to our first health scare. However long you’ve been invested, it’s likely that you know the feeling of watching the markets drop and the inevitable sinking stomach feeling. Perhaps that feeling and the corresponding worry stayed with us longer than it took for the market and our portfolios to recover and now informs our current financial decision-making. Why then, can few of us mark the moments in time when our investments grew significantly and we celebrated their success?
The psychological term for this emotional attachment is called loss aversion. Loss aversion is the concept that the pain of losing something is twice as strong as the satisfaction of gaining it, simply put: “Losses loom larger than gains,” (Kahneman and Tversky, 1979). This is why we vividly recall the market lows and fail to recall the highs; the highs simply don’t have the emotional effect on us that the lows do. That sudden urge to sell when there’s a market correction is one way loss aversion can manifest in an investment portfolio. Since we’re predisposed to react to losses, it’s important to keep our emotions out of our investment decision-making and instead focus on the big picture. Focusing on short-term changes that occur over hours, days, weeks or even months, whether positive or negative, is not beneficial when investing as a long term strategy.
When it comes to focusing on temporary happenings, recency bias is usually at play. Recency bias is when we unconsciously use our recent experiences and memories as the standard for what we expect to happen going forward. We continue to buy, buy, buy when the market is going up because we’re certain it’ll keep going up because that’s all we’ve seen it do lately. On the flip side, when the market is dropping, we’re convinced it’ll never go back up again and the urge to cash out our portfolio is common. Neither of these actions are beneficial to the long-term growth and stability of our investment portfolios, but it’s difficult to separate from these feelings and evaluate our thoughts objectively. This is where working with a trusted professional, like your CPA or financial advisor, can help keep you grounded in your long-term plan.
Another psychological concept that can influence investing is selective memory. Selective memory is when we remember the good things that have happened and forget the bad. This can cause us to only recall our favorable investment decisions and forget our mistakes (or rationalize them away as being not as lousy as they were). Learning usually involves trial and error, so if we don’t acknowledge the actions we took that hurt our investments in the past, we could end up repeating them or becoming overconfident in our investing capabilities. Overconfidence skews perception towards the positive and removes reality from the picture and can lead to riskier behavior than we’d normally take. Studies have shown that overconfidence is the “…strongest predictor of risk-taking,” (Samson and Ramani 2018).
Determining how much risk is right for you and standing strong during market fluctuations can help you avoid emotional or overly risky decision-making. If you work with a financial professional, you’ve likely had the risk conversation. This discussion gives you and your investment manager the opportunity to establish how much risk you’re comfortable accepting. The appropriate risk level for you considers your overall financial picture: earning potential, future plans, liabilities, liquidity needs, and tax sensitivity. The goal is to strike a balance between reaching your financial goals and allowing you to sleep soundly, thus not taking on more risk than necessary.
Understanding some of the investing psychological traps to which you’re predisposed can help protect your investment portfolio over the long-run. It’s important to understand and select an overall risk level that fits your specific comfort level with market risk as well as your lifestyle and financial goals. Your financial advisor can help guide you in terms of your appropriate level of risk, in addition to helping you maintain objective decision making when it comes to your portfolio. When markets fluctuate, instead of reacting based on emotions, revisit your risk level and portfolio diversification – they are your guiding light in uncertain times. Finally, stay in touch with professionals like your financial advisor and CPA. Doing so can help you manage the strong emotions that often accompany market corrections.