Financial Watch | May 2020

Staying Rational About Your Investments, Even Through Volatility

Right now, it’s easy to look at the ups and downs of the markets and want to get out altogether. Emotional investing—or having a knee-jerk reaction to a single market event—can quickly derail progress toward your financial goals. Generally speaking, investments are designed for the long term, and the strategy we’ve created together is no different. The anxiety you may be experiencing now is totally normal. Making a rash decision isn’t.

Behavioral finance, or how psychological influences or biases can affect what we do with our money, is something we all deal with, whether we realize it or not, and emotional investing is a familiar pattern. Here are a few other common behaviors you may have heard of (or even experienced yourself!):

Availability heuristic: If you find yourself reluctant to invest in something because “the market always crashes,” you may be overestimating the frequency of events based on how easily they come to mind. Average market gains over long periods don’t grab the headlines like market crashes do. You might be more risk tolerant than you think you are; you may be focusing on memorable stories instead of less memorable but more reliable statistics.

Status quo bias: Staying the course is one thing, but never deviating is another. There are a lot of investment choices out there, which can lead to overwhelm about making the wrong choice. However, indecision and the resulting inaction can carry their own opportunity costs, causing you to miss potential upsides or other benefits.

Loss aversion: People are more sensitive to losses than gains, and the pain associated with a loss is generally considered to be twice the magnitude of the pleasure associated with the same gain.¹ This works both ways: you may be hanging on to a losing investment instead of opting for securities with better prospects, or sell a high-performing stock now to avoid future losses.

Endowment effect: We tend to value what we already own more than it’s actually worth. This is especially true if that object or investment has an emotional attachment. Inherited securities could go against a defined portfolio strategy but the owner feels an obligation to hang on (even if it causes a loss).

Familiarity bias: Humans tend to be drawn to the familiar, be it people, brands, or even investments. Sticking only to what you know can lead to overweighting in a certain type or sector of investments and a lack of diversification—leaving you open to risks if the sector underperforms.

Mental accounting: There’s a tendency to treat money differently based on its source or planned use, even though it has the same value. This is often a way for people to exercise self-control and simplify their finances (like having a vacation savings account separate from regular savings). However, it could mean you’re putting money in locations where it doesn’t work as effectively toward your financial goals.

Making Sense of it All

We can’t help how we feel, but we can recognize when those feelings are steering us in a certain direction and stop them before we act—and we can work together to help you overcome these behaviors with informed, tested investment strategies. If you’re feeling anxious, or want to discuss these scenarios in more depth, please contact the office at any time to schedule an appointment.

^{1 A. Tversky, D. Kahneman. (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty. 5, 297–323.}

^{A diversified portfolio does not assure a profit or protect against loss in a declining market.}