This week I asked a guest blogger to cover the topic of investing and emotions. Emotional investment mistakes can cost you far more than picking the wrong stocks or bonds after all.
Mike Garry, CFP®, JD/MBA of Yardley Wealth Management has a wealth of insight on this topic. Mike is a seasoned financial planner and estate planner, and through his extensive career working with investors he notes 7 ways many investors goof up their investment portfolio.
Here is Mike’s guest blog post:
Are You an Emotional Investor?
For most people, when asked this question they think “No. I am pretty logical when it comes to money and investments.” However, if you really think about your money decisions on a day-today basis, are they truly logic based and unaffected by emotions?
The study of Behavioral Finance has revealed that “repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty.”
There Is Truth In Theory
Shouldn’t potentially life-changing choices about your own financial future deserve careful consideration and perspective?
The main points of the behavioral finance study can be summed into seven areas of observation.
Loss aversion – Roughly translated, the good feelings generated by a $2 gain on an investment are exceeded by the negative feelings prompted by a $1 loss on a similar investment.
Overconfidence – People are overconfident about their own abilities to make sound investment decisions, this overconfidence spurs too little diversification in a portfolio which increases risk.
Procrastination / Inaction – Optimistic behavior pushes the individual into denial that a bad investing decision needs to be terminated. Investors avoid selling or rebalancing a portfolio after having made a bad investment decision due to fear of admitting that they were wrong.
Herd Mentality – People tend to give too much weight to what the other people are doing believing that they possess an ‘insight’ that makes their decision more accurate. Behavioral finance experts also found that investors tend to place too much worth on judgments derived from a small sample or a single “expert” source.
Mental Accounting – Investors sometimes separate decisions that should, in principle, be combined. This concept states that people tend to segment their money into separate accounts for different goals, when in fact the funds derive from the same source. The best way to avoid mental accounting is to concentrate on the total return of your portfolio and not fixate on what happens to a single stock or mutual fund.
Framing – How investors tend to look at a problem results in how they perceive, or frame, the issue mentally. For instance, hospitals can either report ‘survival rates’ or ‘morbidity rates’. However you look at the numbers, they are still the same basic facts. The framing constitutes how optimistically or pessimistically the situation is viewed.
Representativeness – Investors tend to look only at short term performance when selecting a purchase. Representativeness leads to a knee-jerk reaction to short term fluctuations in the markets causing multiple trades and eventual financial loss. The single win intermingled with several losses also reinforces the belief that to make the big payout, a few losses are to be expected.
Focus On Your Goals
It is very difficult to recognize the emotions behind your behavior before making a decision. The purpose of of financial planning is to help you focus on future goals by helping you create a meaningful vision of your future, a sound strategic investment plan, and then implement that plan with investment decisions based on unbiased facts and research. Often times, investors will exhibit one or more of the behavioral traits listed above and a financial advisor will need to weigh the effects of each behavior in order to make recommendations that will meet the investor’s emotional and financial needs.
Michael J. Garry, CFP(R), JD/MBA, is the owner of Yardley Wealth Management, LLC, is an independent Financial Advisor who provides Fee-Only financial planning services and investment management in Newtown, PA, and the author of Independent Financial Planning: Your Ultimate Guide to Finding and Choosing the Right Financial Planner