Are You Making Financial Choices Based on Logic or Emotion?

Key Takeaways  

• No matter how much we try, it can be hard to stick to our plan when volatility, stress and emotion come into play. 

• Behavioral biases can be especially challenging for couples since spouses often have differing degrees of risk tolerance and investment confidence. 

• A skilled advisor can be an objective sounding board to counter emotional decision-making and keep you aligned with your plan.  

While working toward my master’s degree, I recently took a fascinating course on investor psychology and wanted to share a few key points with you. The course focused on behavioral finance and scenarios in which people’s emotions override their rational decision-making capabilities and causing them to deviate from their financial and investment plans. That’s one of the most important reasons to work with an advisor. They can be a voice of reason during turbulent times in the market, in the economy or in your personal life - and keep you grounded and on track. 

In fact, we cover some of the more common behavioral finance pitfalls in our initial meetings with Novi clients: loss aversion, herd mentality, overconfidence bias, confirmation bias, sunk cost bias and the fallacy of break-even to name a few. These biases often cause investors to be their worst enemies. 

As the chart to the left shows,  the average equity fund investor's efforts to outguess markets – and go in and out of the markets at the wrong times – causes them to lose on average over 2% per year in returns. So over 30 years, they forego over $800,000 in returns on an initial $100,000 investment ($1,817,754 vs. $1,009,064).  Another reason to use an advisor is that many couples don’t have the same risk tolerance and the same relationship with money. As an objective third party, an advisor can be an effective referee and sounding board, that can help couples find a happy medium in their plan. 

There's also the benefit for couples of having someone look at all their accounts in their totality. By doing so, we can invest certain accounts in a more tax-efficient manner as opposed to having each spouse’s account invested individually. We spend a lot of time trying to explain the big picture, and how that ties in with the behavioral side. An individual account might fluctuate more than an IRA account or vice versa, depending on the situation. So, we're always trying to get that big picture across to clients and get them to agree on what’s in their best interest. 

You may be more susceptible to behavioral finance than you think.

 I realize the term “behavioral finance” or “behavioral economics” sounds abstract. But think about the last time you made a big gain on a stock pick. It felt good, right?  Now think about the last bad investment you made. I bet that felt much worse and was likely to keep you up at night for a while and make your stomach hurt. If so, you are not alone. Behavioral finance tells us that the average investor (or gambler) feels the pain of a loss twice as acutely as they experience the joy of a gain. Behavioral finance theorists call this “loss aversion.”   Here’s another example. The markets have been very strong over the past two-plus years. Clients tell us all the time they are okay with a drop of 10% to 15%. They tell us they’ll use the dip as a buying opportunity following the plan we set up. But, when the correction actually hits, what happens? They start panic-selling or second-guessing themselves and forget about their plan. That’s what contributes to wealth erosion over time. Behavioral financial theorists would say this is a combination of loss aversion with “recency bias” aka “intention-action gap.” 

On the flip side, during a bull market like we’ve seen many clients get overconfident and start asking if they can take on more risk than their plan normally calls for. We have to remind them that based on the risk assessment test they took when we first started working together, they won’t be able to handle any more risk than they currently have. If they do, we remind them they’ll be a nervous wreck next time the markets go down. Sometimes in a buoyant market they’ll even ask to re-take the risk assessment test which will just cause them to manipulate the answers to appear more aggressive since the market is going up. Behavioral financial theorists call this “overconfidence bias.” 

As part of our mission to help clients understand their behavior biases, we want them to be opportunistic with their investments as well. Sustaining a few losses can be advantageous for tax planning since it can help you neutralize the gains from other investments, aka “loss harvesting.” 

And when markets are in decline, that’s a great time to buy great stocks at a discount, not to sell in a panic. 

As investor Cullen Roche said: “The stock market is the only market where things go on sale and all the customers run out of the store.”   

Conclusion  

When it comes to investing and saving for retirement, don’t be your own worst enemy. Working with a skilled advisor will help you construct a risk-appropriate plan that succeeds in all market climates and give you the discipline to stick to it. If you or someone close to you has concerns about your portfolio allocation or risk exposure, don’t hesitate to reach out. I’m happy to assist.  Financial Choices Logic or Emotion

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 BRENDEN LEESE, CFP® is an Associate Wealth Advisor at Novi Wealth Partners