We like to think there are times when humans can be 100 percent rational, but in reality, our emotions are always influencing our decisions whether we want to acknowledge that fact or not.
In fact, one of the most famous mathematicians of all time, Godel, based his foundational incompleteness theorem partially on that point. The universe is likely objective, but humans cannot always objectively measure, observe, or even understand it.
So stop fighting your irrationality. You’re officially off the hook.
Fear plus greed and your finances
Financial principles have always been based on rationality. The early theories of finance assumed as their foundation that humans will behave predictably and rationally when making financial decisions. Theorists believed people could put aside emotions and outside factors when making decisions about their finances.
Fast forward to now.
Behavioral finance understands just how much influence outside factors and emotions have in making decisions, even in the area of finance. It turns out that humans behave differently in the real world. The brain has trouble assessing risk, otherwise known as fear, and possibility, otherwise known as greed, rationally. This is where our emotions take over.
Investors make irrational decisions about their finances when things like risk and greed are in the mix. They react more strongly to loss rather than to gain. The pain of loss usually outweighs the positive feelings of gain, even when a portfolio shows mostly increases.
Fear and greed impact our portfolio nearly as much as the underlying performance itself. You can’t escape your emotions when it comes to this area. This principle is so prevalent that there’s even a fear and greed index that tracks trends in the overall market.
Who are you?
Knowing yourself is the first step to using your emotions to your advantage. If you can’t outrun them, you can understand how they affect your decisions. For example, how do you react to volatility in the market? Are you likely to sell or invest right away, needing some active change to handle your fear, or do you hold on to what you have for stability?
Now you’re beginning to understand. In another example, do you tend to follow the herd by buying what is popular now, or do you take risks on unproven investments? Warren Buffet, likely one of the most successful investors of all time, said, “Be fearful when others are greedy, and greedy when others are fearful.”
Not that Buffet’s advice holds true for everyone. The point is that Buffet knows himself pretty well, and that’s how he manages his portfolio. Instead of focusing on the objective, instead, discuss your hopes and fears with your advisor so that he or she can get a better idea of your emotional triggers. You can both mitigate some of the bad decisions you’ll make from fear or greed.
Fear and greed can be positive.
Both of these emotions have negative connotations but thinking of them in terms “risk tolerance” and “possibility” helps put them into perspective. Greed helps you to take chances on things that will pay off in the long run and becomes harmful when taken to the extreme, otherwise known as gambling.
Fear is also positive. It keeps you from hopping on every bandwagon investment. It becomes negative when your fear of loss is so intense that you miss opportunities to round out your portfolio.
Understanding your motivations helps you be a better investor. Decide how much risk you’re comfortable with and how you’d like to divide your portfolio investments. Now you’re ready to work with your emotions, not against them.
The best way to harness fear and greed
There are objective factors that go into your portfolio. These include gender, age, and income level. They also include your purpose for investing, for retirement or college for example, and your current tax situation.
The area of focus is a significant objective factor influencing your investments. The type of investment you prefer does depend on your emotional reactions to the market, but an advisor can give recommendations based on either the sector of your investments, like technology, or the kind of investments you make, such as government bonds or mutual funds.
As you talk with your advisor about your portfolio, discuss it concerning your dreams and your fears. This gives the advisor a better understanding on how your mind works and what you hope to do with investing.
Your risk and reward behavior is part of this. Tolerating more risk stands to get you higher reward, but this doesn’t align with the desire to see retirement saving safe and sound. Resisting risk for a more stable portfolio doesn’t align with the desire to cash out for a vacation or some reward in five years or fewer.
These goals that you have shed light on how an advisor should steer your investments far better than trying to behave rationally. Taking advantage of your aspirations and core desires will create a better portfolio in the long run than trying to avoid emotional decision making.
Stop running from your emotions
Rational decisions about your portfolio set you up to fail because your portfolio won’t reflect your natural tendencies. It works directly against your fear and greed responses, setting you up to fail as an investor.
Financial planning is just as responsive to your natural emotions as any other decision. By understanding yourself and by working with an advisor that understands your needs, you can create a portfolio that takes advantage of and doesn’t work against these emotional decisions.
So what kind of investor are you? We’d love to know! Schedule an appointment with one of our advisors today and find out how you can keep fear and greed in check with your portfolio.
*Advisory services offered through Trajan Wealth, L.L.C., an SEC registered investment adviser.