Is Reason or Emotion in Charge of Your Wealth Plan?

Is Reason or Emotion in Charge of Your Wealth Plan?

October 20, 2021

If you are like me, you would like to believe that you are logical and rational. The fact is we are all human. Everyday life has helped shape perceptions and emotions. Even if we consider ourselves open-minded, we have biases. Good, bad, or indifferent, these biases influence your feelings, behavior, and future decisions. 

Since investing at its core is deeply personal, it’s not a surprise that behavioral bias comes into play there too. An investment plan should not only be tailored to your needs, your goals, and values, they should also incorporate your preferences for risk. It can also be helpful to watch out for ingrained predispositions that can affect your investing choices. The good news is that these biases tend to apply broadly across investors. It is up to you to take steps to recognize and correct them. 

There’s a whole science around investor bias, but we’ve broken down the four that we often see. Do you recognize yourself in any of the below situations?

Nobody Likes to Lose, But…

Loss aversion is probably the most common emotional or behavioral bias, and to some extent, it’s a good thing. It refers to how most investors are far more sensitive to the pain of losses than to the satisfaction of gains. It could be good when it results in an investor structuring a portfolio that avoids risky investments. However, it can also mean you are missing out on investment returns because you are avoiding risk. Women investors may be particularly susceptible to this bias. Instead of being heavily invested in the markets, they tend to hold a very high proportion of cash.

Many investors find themselves on the emotional investing roller coaster and subject themselves to the typical harmful pattern. A position falls, the investor is upset with performance and sells, crystallizing the loss, only to buy something that has already gone up and may not have any upward trajectory left. 

One solution is to map out various investment scenarios in different market environments to find a realistic risk tolerance. Focusing on the long term and creating a sensible asset allocation that performs reasonably inside previously known parameters is a step in the right direction. Setting up an automatic rebalance or working with an advisor who understands your risk limits can help to ensure that decisions around changes are not made in times of stress or based on fear. 

Familiarity Can Sometimes be Too Comfortable

We all have our “go-to” things that we trust and feel comfortable with, whether it’s a brand, a type of food, or a routine. These are good things that simplify the multitude of choices in life and create congenial systems.  In the finance world, sometimes being familiar with an investment leads some to hold the investment just because it is a known entity, rather than holding the investment because it is the best option. That bias doesn’t belong in an investment strategy. 

We’re not talking about a long-term investment in a brand you know and trust – that can be additive to return, as long as it is part of an asset allocation. Familiarity bias comes into play when an investment is overweight in a portfolio, despite changing information, or in favor of better choices. It isn’t limited to a particular company or brand; it can be in a sector, such as technology or even a country. 

This Time is Different!

Overconfidence bias is when we highly value our own skills at a given task and are skeptical of others’ skills. For example, AAA reports that 73% of Americans consider themselves to be better-than-average drivers. This is statistically impossible – but try telling that to most people. That same overconfidence in one’s skill can lead to risky investments that fly in the face of available data and sometimes just plain good sense. Typical investing behaviors here can include attempts to time the market or overweighting an asset that the investor believes will outperform. 

The Nobel prize-winning “father” of behavioral finance, Daniel Kahneman, developed a process to counter your bias. It involves projecting at least five years into the future and assuming the stock met expectations. List all the reasons why. Now imagine the stock came up short. Again, list all the reasons why. This technique can help to impose logic on an emotional decision and cut through the fog of bias. 

Everyone Else is Doing It, What Could Go Wrong? 

The classic parental mantra sited when you want to do something perceived as foolish rings true in investing. If your friend jumped off a bridge, would you, do it? The results of trend-following in investing can go way beyond the embarrassment of doing something silly because everyone else is. Trend-following is a legitimate trading strategy that attempts to capture investment in a stock whose price increases and then sells as it starts a downward trajectory. There are many ways to deploy the process, from old-fashioned day traders who develop their mechanisms and “feel” the markets to sophisticated AI with many factor inputs. At the core, however, they rest on the belief that price trends will continue.

The problem is that prices in markets move because enough investors believe the same thing about a stock. The irrationality built into human behavior means that prices can overshoot well beyond the fundamentals as more people jump on a trade. Or the opposite can be true, and prices can drop precipitously as sentiment changes. We believe that in the long run, the fundamental qualities of an investment ultimately win the day. For most investors, thinking clearly about goals and building an asset allocation that isn’t dependent on this strategy is better to win over time.

The Bottom Line

Investing styles reflect who we are. But since you’re investing for the future, keeping the fluctuations of day-to-day emotions out as much as possible will generally result in a better long-term strategy. Working with a financial advisor that can help you identify your inherent biases can go a long way towards crafting a process that can move you toward your goals.

This material is provided as a courtesy and for educational purposes only. Investing involves risk including loss of principal.  Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation. This article contains links to articles or other information that may be contained on a third-party website.  River City Wealth Management is not responsible for and does not control, adopt, or endorse any content contained on any third-party website. The information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. Past performance is not indicative of future results.