If you work with a financial professional, most likely they’ll hand you a series of questions to determine what kind of investor you are. Whether we like it or not, investing our hard-earned money triggers emotions, such as excitement, fear, and optimism along with behaviors like following what everyone else is doing or clinging to certain beliefs. We might not even be aware of how these emotions and behaviors affect us, but, unless you’re a computer algorithm, it’s a common experience.
Behavioral economics is the study of the psychological reasons behind the choices people make with money. These behaviors are usually triggered by our emotions, which you may have heard, is the one thing you should keep out of your financial decisions. But that’s easier said than done.
Most financial professionals use a “risk assessment questionnaire” to help them determine how you’ll potentially react emotionally and behaviorally to financial volatility so they can help you invest in a way that you are comfortable with, from aggressive growth with high risk to conservative stability with low risk.
Here are some sample questions to see where you land or you can take a look at the Transamerica questionnaire.
What are the goals of your retirement savings?
- Protect the value, minimizing chance for loss in exchange for expecting lower returns
- Seek higher returns but still minimize risk
- Go for long-term growth and accept extreme fluctuations in gains and losses along the way
How would you react to a drop in the stock market that results in losses in your investment portfolio?
- Buy more while the price is down
- Sell to avoid future losses
- Continue to hold investments for the long-term
How would you feel if your portfolio experiences losses?
- Fearful, panicky, and wanting to sell
- Confident in the long run and comfortable with holding steady
- Unsure and looking for other options to trade out
The effects of emotions on investing
Does this look like your emotional journey when you invest?
In a previous article, we talked about behaviors that can get you in trouble when managing your money. You can see how some of these tie in to the investor sentiment cycle above.
The impact of common behaviors
Framing – Looking at one narrow perspective (one stock movement) and reacting emotionally instead of zooming out to see your bigger picture, long-term goals.
Overconfidence – Feeling euphoria when you picked a winning investment, then experiencing everything from denial to panic when it takes a downturn.
Herd behavior – Doing what others do, whether it’s rational or irrational. You may have purchased an investment because everyone else was. You’re happy when it goes up but hang on too long until it takes a downturn, then you may panic and sell it at its lowest point.
How to tame emotions
Money is personal. You work hard for it and carefully stash it away. It’s easy to be emotionally invested in its value and what it can afford you in life. Nobody wants to lose money. The very nature of the stock market, with its ups and downs, is a test of our emotions.
But in order to maximize the potential gains investments have to offer, you must be willing to accept that it comes with volatility. So how do you keep from getting upset with this rollercoaster ride? Here are some suggestions:
Remind yourself that you’re in it for the long haul. Unless you’re planning to become a day trader and move your investments around on a daily, or even hourly basis, and spend your life staring at technical charts and constant movement of the stock market, most of your investments will be for long-term goals to make sure you have enough money for retirement. Do check in on them at least once or twice a year to see how they’re performing or work with a financial advisor for guidance, but avoid obsessively looking at them all the time, which could lead to rash decision-making.
Just like the name sounds, robo advising is basically a robot that is your online portfolio manager. It follows the stock market for you via computer algorithms set up for your risk tolerance and retirement time horizon. Your investments will be automatically rebalanced based on monitoring on your behalf, giving you a hands-off approach that leaves your emotional tendencies out of it. Many investment platforms now offer this service, often at a lower cost than working with a human advisor. Check with your employer’s 401(k) custodian or retirement plan’s manager.
Dollar cost averaging
If you plan to invest a specific amount on a regular basis, set up a dollar cost averaging investment plan with a broker to do an automatic transfer into a predetermined portfolio. The money you move over stays the same but how many shares it buys is dependent on the price at the time. Without you ever having to watch the stock market, you buy more when the price is low and less when the price is high so that in the long run, you’re buying the shares at the “average” price. No freak-outs needed. Remember, dollar cost averaging does not guarantee a gain or loss.
Ease your emotions through diversification by investing in different types of investments across the market. This helps provide protection from volatility in market conditions. When one sector is down, another may be up, providing balance and reassurance to your sensitive side that all is not lost.*
Work with a financial professional
If you’re working with a financial professional, you’ll want to check with them at least once a year to see if you‘re meeting the goals you laid out in your financial strategy, but trust that they’ll rebalance as needed to get you there.
Controlling your emotions and behaviors around your financial decisions can be tricky. But with some modern tools and help from a financial professional, you can stay on track and keep your sanity in check.
Things to Consider:
- Take a risk assessment to see if you’re an aggressive or conservative investor.
- Be aware of how emotions can impact your financial decisions.
- Use financial tools to avoid taking investment volatility personally.
*Investing involves risks, including loss of principal, and there is no guarantee of profits. Investors should carefully consider their objectives, risk tolerance, and time horizon before investing. There is no assurance that any fund will meet its stated objective.
1“Cycle of investor emotions,” Barclays, accessed February 2019.