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How do we manage our clients’ behavior, and by extension, our own behavior, when negative headlines and concerning events dominate the markets? It certainly isn’t easy to maintain objective long-term investment plans when the short-term outlook seems ominous, especially knowing that markets are largely driven by two emotions, greed and fear. These emotions affect investors very differently with fear being more dominant and more impactful to retail investors’ actions. To be an effective investor, it is important to deal with these emotions separately.
In an attempt to remain objective, we need to acknowledge the following information:
- Investors tend to seek pride and avoid regret when making investment decisions.
- Investors emotionally suffer more greatly from losses than they benefit from gains; psychologists describe this as the disposition effect.
In plain English, losing $10 is more impactful than gaining $20. This emotional toll is even more significant if the investment decision that created the loss can be tied back to the client’s own choice. These factors cause people to make decisions based more on emotions than economics, a pitfall that should be avoided at all costs as they rarely produce the desired result.
In his book The Psychology of Investing, John Nofsinger lays out the following steps to help avoid making emotional decisions with our investments:
- Understand the biases
- Know why you are investing
- Have quantitative investment criteria
- Diversify
- Control your investing environment
Of these, controlling one’s investing environment is the most important in times of fear. Investors can control their environment by tuning out the constant barrage from investment news networks that play to these emotions to gain more eyeballs, clicks, and screen time. These outlets treat every market day like the Super Bowl and portray homogenous investment expectations (time horizons, risk tolerance, liquidity needs, etc.).
Most long-term investment and financial plans do not require hourly monitoring of the securities markets, therefore, monitor your investments on some pre-determined interval. Certainly stay informed of market developments, but don’t make decisions based on an emotional response. Instead, employ quantitative investment criteria to ensure your decisions tie back to something economic.
Monitor your investment performance on an annual basis against a set goal and make adjustments as your portfolio outperforms or underperforms that goal. Being aware of the traps set by our emotions helps us objectively avoid those traps and make more effective investment decisions. This allows us to enjoy the horror from Hollywood instead of succumbing to the fears of market headlines.
