The Role of Emotion in our Investments

The Role of Emotion in our Investments

June 06, 2023

The longer that I am in this industry and the more people that I talk to, the more I am convinced that the biggest impediment to someone reaching their financial goals is themselves. I used to think that it was purely a matter of education. Our industry has done a notoriously terrible job in the area of personal finance education (as has the public school system I might add). So early in my career, it stood to reason that if I could simply help my prospective clients to understand how the market works then all should be well. I have printed off more investment hypotheticals than I can count in order to prove to prospective clients that if they simply stop worrying then things should go swimmingly for them!

While I still believe that a lack of proper education is to blame for much of our country’s financial woes, I no longer believe it is the sole or even the primary driver of financial distress for most people. What I believe is to blame for the vast majority of financial mistakes is not head knowledge but rather one’s response to market events happening in real time. To put it simply, people tend to get in their own way even when their actions contradict what they know to be true in their heads. Why do people do this? Their emotions get the best of them and it happens to all of us! We are predisposed to avoid pain, fear, and anxiety.  There is a whole study of this phenomenon called “behavioral finance” which I do not feel qualified to speak in depth about. Suffice it to say that people do unwise things with their money when they are under significant stress.

One such imprudent action would be to commit what I often refer to as the, “Big Mistake” (I didn’t coin the term, author Carl Richards did). The Big Mistake is the act of buying when the market is at a peak and selling when it is at the bottom. This is not a particularly heady topic to understand. Most people get that you should not sell your investments for less than you paid for them. Yet, it is an incredibly common mistake! I wrote a short blog post on this very topic last year which you can find here.

However, in today’s post I want to talk specifically about selling when the market is low. Obviously, this is not ideal and would certainly have an adverse effect on your investments but nothing that a few good years can’t fix right? Well, depending on when you sell and when you get back in, maybe not. Take for example the worst market we have had thus far this century: the Financial Crisis of 2008. In 2008, the S&P 500 was down -37% for the year (and we thought 2022 was bad!). To make things even more terrifying for investors, the S&P 500 fell a total of -48% from its peak in August of 2008 to March of 2009[i]! Given what we have already discussed about the emotional tendencies of human beings, it would not be surprising for someone to have dumped their stocks at that point in time. Even with all of the financial education in the world the need to avoid pain, anxiety, and stress pushed many people to bail on their investments at the very worst possible time. However, returning to the original question of this paragraph, would a few good years fix this “Big Mistake”? Taking a look at the chart below will give you your answer:

It is likely obvious to you that staying out of the market from 2008 until now would result in vast underperformance vs the S&P 500. But what if you stepped out of the market at the low of 2008 and got back in exactly one year later? Taking a look at the chart, someone who invested $100k in 2003 and held their investments through the lows of 2008 would have experienced an annualized return of 9.79%. If that same person pulled out of the market for one year in 2008, their annualized return would have been 6.82%. In dollars, this is almost a $300k dollar mistake!

In the example, notice that you don’t need to stay out of the market for an extended period of time in order to severely hamper your investment performance. Additionally, I would ask you to consider this question in regards to pulling your money out of the market: “When do I get back in?” Clearly a year can make a huge difference. What about 2? How about 6 months? The point is that by pulling out of the market, particularly at the bottom, you have now put yourself in the unenviable position of trying to guess the right time to get back in. Not even the best investors in the world get that question right 100% of the time!

So why am I telling you all of this? After all, if our emotional response to swings in the market is just part of human nature then isn’t the result inevitable? I would argue that this is certainly not the case and that there are a couple of things that you can do today in order to safe guard your investments from yourself. The first thing that is vitality important to know is yourself and your own ability to tolerate volatile swings in the market. Here is an area where you need to be brutally honest with yourself! There have been times in my career where a client has told me that they are aggressive investors only to find out that they are terrified by dips in the market. Don’t lie to yourself about how much risk you can withstand. Yes, you do need to assume some risk in order for your accounts to grow but perhaps less than you are taking now. A good rule of thumb: if your investments are keeping you up at night then you are probably invested too aggressively.

Secondly, it may be prudent of you to find someone who can provide you with an objective perspective and keep you accountable to your financial plan. Important here is that in order for someone to have an objective opinion they need to not be directly impacted by your financial decisions. This means that a spouse or family member probably isn’t the best person to ask for an objective opinion. A better option would be to find someone with knowledge of the industry, whom you trust, but doesn’t have the same emotional ties to your money that you do. See where I am going with this? Yes, a financial advisor can help to fill this role for you and perhaps prevent you from making otherwise disastrous mistakes with your money.

I will leave you with this. When investing for the future, it is ok to look at the markets and your investments to see how they are doing. It is even natural to have some anxiety when things are not going well. But for every one look you take at your investments, take 10 looks at your financial plan, the numbers of years you have until retirement, and the goals that you have planned. And then call up your financial advisor for reassurance 😊

Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.