By Gary Brooks
AdviceIQ.
When managing personal finances and investments, people frequently exhibit irrational behavior for different reasons. If you’re one of these folks, be fair to yourself: It doesn’t even take a spate of market zigzags like October’s to prod you into questionable decisions.
Everyone makes choices about money nearly every day, how to earn, spend, save, invest and so on. Sometimes you pick wisely, sometimes harmfully. Some decisions, particularly those regarding when and where to invest, whipsaw from wise to harmful and back, depending on when you reached your conclusion and when you took the plunge.
Supposedly, if you can learn more about the cause and effect of your money decisions, and what around you contributes to them, you will improve your financial security. Pinpointing behaviors as either rational or irrational in the middle of the storm comes hard, though. The October market provided a convenient and timely case study to help explain why.
That month, the Standard & Poor’s 500 Index of large U.S. stocks declined 5.6 percent through Oct. 15 and then gained 8 percent through the end of the month. If sensitive to market moves, maybe you read the swift early declines and sold big, a flight perhaps revealed as irrational, given the late-October rally that continued into November.
If you sold in mid-October, you likely showed loss aversion, one of many often-irrational money behaviors. Psychologically, people perceive losses (or declines in value of an investment) as much as 250 percent more impactful than gains of a similar size. Watch your investment drop $1,000 and you feel more than twice as bad as you might feel good about a gain of $1,000.
Most people are loss averse; it’s clear why many sell when market prices decline. Is loss aversion irrational? Or sometimes, is it timely clairvoyance?
Rewind to 2007, when from Oct. 9-19 the S&P 500 quickly declined more than 4 percent, similar to what it did in early October this year. Let’s say you were one who sold Oct. 15 this year (and looked irrational in hindsight). Let’s imagine further that in early October 2007 you also cut back your market exposure under these similar conditions.
Instead of irrational, you would have appeared brilliant. Oct. 9, 2007, was a high point; financial apocalypse reigned for the next year and a half.
What-if situations such as these clearly show that sometimes irrational behavior produces good outcomes. And sometimes well-trained (and often self-proclaimed) experts, applying rational processes to money management, wind up on the wrong side of the intended outcome, especially in the short term. This helps make investing fascinating and, at times, maddening.
Because investment markets are complex and potentially both irrational and efficient, understand well your tolerance for risk. Define what risk actually means in terms of your financial security, and your willpower to handle markets when fear and greed influence decisions.
A written investment strategy can serve as a foundation for your long-term decisions. Your strategy, and your commitment, may also benefit from testing your strategy’s performance hypothetically in past crises.
Since we can’t predict outcomes that depend partially on luck, we plan according to probabilities. For example, rather than focus on the size of your expected returns, know the probability that your investment strategy can support your desired spending rate in retirement or make tuition payments, fund a wedding, cover health-care costs and so on. Your broader financial plan drives your investment strategy, not the other way around.
Ideally, when your goals link directly to your plan, you have a better foundation for dealing with investment uncertainty and Wall Street’s effect on your emotions and decisions.
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ABOUT THE WRITER
Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, and a registered investment adviser in Tacoma, Wash. He writes for AdviceIQ, which delivers quality personal finance articles by both financial advisors and AdviceIQ editors.
