The feeling we get from money, and investing, has deep roots inside our emotions, although we may not understand why. Behavioral science explains why we make our investment decisions and how we emotionally react to them. Behavioral science is the science of ‘choice’ that explores emotional decisions, and behavioral finance studies why investors make the decisions they do.
Even when investors have information that should lead them toward good investment decisions, they don’t always make the appropriate choice for their situation. That’s where emotions come in; our feelings about our investment decisions or lack of decision-making and how we feel. For example:
- Risk tolerance- Risk tolerance measures of the degree of loss an investor is willing to endure within their portfolio. Market volatility, economic or political events, and regulatory or interest rate changes may affect an investor’s portfolio and produce an emotional response, either positive or negative, in the investor.
- Market volatility- Periods of market volatility are normal occurrences that may impact an investor emotionally regardless of the impact on their portfolio’s performance. Risk tolerance assessments measure the investor’s tolerance which aids in constructing a portfolio of strategies that produce positive returns with less volatility and appropriate emotional responses for the investor.
Behavioral barriers are decisions we make due to what we observe in others, cultural beliefs, or an acceptance of our current financial situation and well-being. For example:
- Herd investing- We see others’ success or hear what they invest in and ‘mimic’ what they do. Herd investing can be both emotional and behavioral. Consider these examples:
- Our employer retirement plan is enough because we see the older generation that retired from the same job we have and think they are financially confident.
- We invest in a ‘hot stock’ because we watch TV or listen to a journalist, aka ‘expert,’ tell us we should.
- We invest in the same strategies our friends and co-workers use because they’re financially secure.
- Cultural barriers- Due to their beliefs, an investor may not accept professional advice, is mistrusting, doesn’t believe in investing, or the investor’s sex may determine the role they have in investment decisions and managing the household money. All these relate to cultural barriers if the investor follows their culture’s teaching about money, finances, and investing.
Emotional gap- The emotional gap refers to investing decisions based on emotions such as anxiety, anger, fear, or excitement. Emotions are a key reason people do not make rational choices about when investing or the investment strategies they choose.
Making impulsive decisions during market volatility- Thoughtful planning can help investors feel more confident during market volatility and help circumvent impulsive decisions that may impact their portfolio negatively.
For example, selling and reinvesting or pulling out of the market during periods of volatility may result in losses that can’t be recouped. Instead, wait for a market correction and reallocate, rebalance, continue investing, and follow your financial plan.
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These barriers are typical and part of what makes each investor and their situation unique. Financial professionals work to convince investors to make rational investment decisions and coach them away from destructive investing behaviors that may impact their financial independence now or in the future.
If you have concerns about the economy, stock market conditions, or your portfolio allocations, now is a great time for us to meet and review your portfolio.
