These techniques can help you keep your emotions from crippling your investment decisions.
Smarter investing is all in your head.
Really, it is, say psychologists who research investor behavior. Use these five techniques to psych yourself into better results and more peace of mind at the same time.
1. Do less to earn more. It’s counterintuitive, because Americans tend to equate activity with progress, but less fiddling with your portfolio will likely yield better results, says Brad Barber, professor of finance at the Graduate School of Management of the University of California–Davis.
“Making too many trades usually hurts performance,” Barber says. There are two reasons for this. First, most people are overconfident about their own abilities. Secondly, “People enjoy engaging in the spectacle and the game of the market,” he says. “They think it’s fun, and they think they’re smarter than they are.”
2. Understand that what is happening might not keep happening. Assuming that current trends will keep on is called “recency bias,” says Charlie Bilello, director of research for Pension Partners, a mutual fund manager based in New York.
“It’s the worst trait you can have as an investor,” Bilello says. “And it’s affecting you, unless you are 100 percent objective. Investors tend to see what’s doing well – maybe an asset class or a slice of the stock market – and we are wired to believe that it will continue, so we extrapolate the present into the future.”
For example, Bilello says, “most investors think that whatever did well last year will repeat this year.” Currently, this means many investors want to put more money into U.S. stocks, because that category has been outpacing its global peers.
The truth is that markets tend to revert to long-term trends, Bilello says. When a high-flying stock comes down to earth, investors think it’s crashing, when in fact it is simply realigning with long-term trends. That’s when recency bias – assuming that this high-flyer is different – turns against you, Bilello says.
The antidote to recency bias is asset allocation, “and not shifting the allocation based on what has gone on in the past few months, but rather according to the investment criteria you have laid out in advance, and through regular, disciplined rebalancing,” Bilello says.
3. Don’t delude yourself that owning your employer’s stock means you are helping to build your own future. Nice try, Barber says. Although it’s great to get employer stock through employee-stock ownership plans or as bonuses, “it’s not a bad thing unless it becomes an unusually large part of your total wealth. Then you need to diversify,” he says. But people’s assumptions go awry when they believe that, by working hard at their jobs, they are contributing to company results that will filter through to stock value and, thus, their own financial future.
The gritty truth, Barber says, is that your little push toward profitability is more than overshadowed by economic factors out of your, and your employer’s, control. Look no further, he says, than the recent plummet in oil prices to understand how forces you can’t control can change your employer’s stock value. That’s why it’s so important to contain your employer’s stock to a slice of a diversified portfolio. “It’s a fallacy that you can control the value,” Barber says. “You can’t.”
4. Don’t overestimate your tolerance for risk. It’s easy to think you have a cast-iron stomach, says Joyce Schnur, vice president of financial services and dean of the Kaplan University School of Professional and Continuing Education, based in Chicago. Your equilibrium will be challenged by tumultuous markets and economic conditions, and you will likely be surprised by your reactions, say Schnur and other experts.
Prepare by thinking about the worst investment you have ever made, Schnur recommends. “Your reaction to that helps you understand what your loss tolerance is,” she says.
Handling seesawing emotions is one component of financial advisor preparation, she adds. Advisors have emotional reactions to the market, too, and they must learn to steel themselves against making decisions irrationally and have a strong enough equilibrium to help buffer their clients’ reactions.
“The biggest thing to understand is that the heat of the moment, whether positive or negative, is not the moment to make a decision,” Schnur says. “Get some distance.”
5. Get a grip. Your emotions literally change your brain chemistry, says Doug Lennick, CEO of Think2Perform, a Minneapolis-based leadership development firm and a certified financial planner. “The first thing is to recognize the emotional state you’re in: ecstatic or fearful. Either one results in chemical activities that will restrict thought. If you recognize, ‘I’m scared because the market just dropped,’ that’s a moment to recognize 'I’m in an emotional state that predisposes me to make an irrational decision,'” he says.
When strong emotions trigger intense reactions, recognize that you are intuitively turning to action – any kind of action – because that’s how you are hardwired, he says.
First, don’t act in the heat of the moment. Second, reflect on your core values and goals. Then, when you’ve calmed down and your rational brain is in control, respond, Lennick says.
By Joanne Cleaver
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which course of action may be appropriate for you, consult your financial advisor. No strategy assures success or protects against loss.
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