Acknowledge but Do not Act on Emotions

By Jane Young, CFP, EA

Emotions and uncertainty are in high gear with Covid-19 and heightened political divisions.  With all the uncertainty we are facing it is natural to feel anxiety about your finances.  It is more crucial than ever to take a disciplined approach and stay calm.   If your situation has not changed you should stick to your plan and avoid making sudden changes driven by emotions.

Researchers have found that a major threat to the performance of your portfolio is uncertainty.   Investors hate uncertainty.   Uncertainty leads to stress and anxiety which negatively impacts decision making. Studies indicate that stress can result in a significant loss in cognitive ability.  Uncertainty can also make you hyper focus on investments, hesitant to take risks, procrastinate and give into temptation by making decisions too quickly.  You are also likely to miss opportunities by choosing an option with a certain outcome over a more lucrative opportunity that carries a reasonable risk.

Two primary emotions impacting our finances are variations of fear and greed.  Our evolutionary brain processes positive and negative emotions in different parts of the brain, like the processing of physical stimulation.  Positive emotions, from a significant gain, are processed in the section of the brain that recognizes physical pleasure from food, drugs, or sex.  Negative emotions, from a financial loss, are processed in the section of the brain that recognizes physical pain.  Biologically, our bodies process a financial loss as a physical threat.  

This helps explains the propensity to avoid loss.  Loss aversion is the reluctance to take an obvious loss and reinvest the proceeds in something potentially more lucrative.  Studies have found that investors feel twice the negative emotion from a loss than pleasure they get from a proportionate gain.

In addition to loss aversion, the following emotional responses that can also be detrimental to your portfolio:

Anchoring – Reluctance to sell a holding until it hits a reference point such as the purchase price or previous high regardless of the fundamental value or projected return.

Overconfidence – Placing too much value in your own capability when markets are rising and blaming outside circumstances when there is a loss.

Confirmation Bias – Seeking out information that supports your preconceived conclusions.

Recency Bias – Placing too much emphasis on and making decisions based on short term news and market activity rather than long term trends.

Herd Mentality – Jumping on the bandwagon to chase the current hot asset class or stock.

It is natural to worry about your investments, but successful investors are disciplined and do not act on their emotions.  To avoid emotionally driven decisions consistently follow a well thought out plan.    Maintain a long-term view and when short term events trigger your emotions, wait 24 to 48 hours before acting.   Emotions travel to the brain faster than rational thought, give yourself time to think.   Spend less time continually monitoring your portfolio and watching financial news.  Maintain a diversified portfolio and establish an automatic investment plan.