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Emotional investing can cause financial heartache

by Joseph Arroyo | Contributor
July 27th, 2021

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We’re all ruled by our emotions from time to time. In some circumstances, like an impulse buy when watching an infomercial, the consequences are minimal.

Sometimes, though, emotional decision-making can have dire consequences. This is especially true of investing. Every investor is susceptible to poor decision-making due to uncontrolled emotions, even the professionals. This can lead to all kinds of risky investment behavior. Just knowing about these dangers isn’t enough, though. You need to incorporate these dangers into your investment plan. Creating, understanding and reviewing your financial plan can help you stay the course and avoid emotional decision-making with your investments.

Why do we make poor investment decisions?

So why do emotional decisions tend to turn out so badly? There may not be just one simple answer, but psychologists Daniel Kahneman and Amos Tversky have done groundbreaking research into a field called behavioral economics that sheds some light on the matter. In their academic work they show, often with amusing experiments and anecdotes, that people predictably make poor decisions when it comes to risk. We tend to make bad choices by switching between two extremes:

  • We are excessively risk-averse and take too few risks.
  • We become excessively risk-prone, take more risk and stay exposed to it for longer than is good for us.

In the first case, we avoid anything remotely risky. When this happens, our portfolios never have the chance to earn enough interest to power our retirement. On the other hand, being excessively risky leads to similarly poor investment outcomes. An example noted by Kahneman and Tversky is that when people have suffered a loss, they’re much more likely to take even greater risk. It’s sort of the reverse of playing with house money. In this case, investors become numb to losses and even embrace them in a twisted way that often leads to further losses. In extreme cases, these losses become catastrophic.

The “professionals” aren’t immune. In the 1990s, a sophisticated hedge fund called Long Term Capital Management ran into trouble after experiencing astounding success. Long Term Capital Management even had two Nobel Prize winners’ on staff. Unfortunately, the managers of Long Term Capital Management became desensitized to losses when the market moved against them. They added to their positions and maintained them, even as the hedge fund was driven to ruin. Their stunning losses “helped” them to take further risk.

chart for loss and gain needed to recoup losses

Another emotional problem behavioral economists and psychologists warn us about is confirmation bias. We tend to interpret data in ways that validate the decisions we’ve made. In the case of investing, that often means that we see no reason to change course. Instead, we stick with our first choice or instinct. So, when a stock we purchased reports bad news or is under-performing, we find ways to make excuses. The result of confirmation bias is under-performance at best and catastrophic failure at worst.

Just to prove to you that the professionals aren’t immune to confirmation-bias either, keep in mind that the people who created and ran Long Term Capital Management created another hedge fund after the collapse of their first. They pursued the same strategies that had betrayed them before. The results probably won’t surprise you. After some years of success, the new hedge fun went belly up in the 2008 market crash.

Another example of emotions causing poor performance is the well-known aphorism among investment professionals that the relatively uninformed, “mom and pop” investors become aggressive buyers of stocks when the market is at the top. The flip side, of course, is that these same investors give up hope and sell stocks when the market tends to be at the bottom.

There are many things that drive these upside-down investment choices; each individual has their own motivations, but what often causes this irrational behavior are two related concepts:

  • Fear of missing out. (It kills you not to make 1,000% on cryptocurrency.)
  • Herd mentality. (Everyone else is invested in technology stocks – they must have a good reason.)

These human emotions lead to a rash of bad investing behavior. The past half century of investing is littered with examples of people who committed one or more of these emotional errors. Whether buying at the top or taking too much risk in the face of known losses, investors tend to lose significantly. These investment losses can impact your ability to successfully retire. Haven’t we all heard about the person about to retire who lost everything (or most of it) in a stock market crash?

Federal Reserve policy is a factor, too

It’s not just that people tend to make poor investment decisions. They’re forced into it in some cases. Investors need to accumulate returns to grow their nest eggs and provide funds for retirement. Traditionally, as people got closer to retirement, they became more conservative in their investments. They’d get out of the stock market and load up on dividend-paying blue chip stocks and bonds that paid good interest.

Unfortunately, Federal Reserve policy has just about made this strategy impossible. Interest rates on government bonds are at or near 100-year lows. Making an income off of bond interest is not feasible, except for those with eight-figure or larger portfolios. Dividends paid have been decreasing for 50 years as companies have increasingly embraced share buybacks. To get higher yielding dividends, today’s investors generally have to purchase shares in smaller-cap companies. These companies tend to be more volatile, which can lead to portfolio losses.

With little or no “safe” income available, aging investors end up “reaching for yield” and purchase and hold investments that are too risky for them.

Investors tend to “chase” performance

People want to do well investing. They have an intuitive sense about how important it is to their financial futures. This explains why investment bubbles have been so prevalent throughout history; people move money into assets that are going up in value. Just in the last three decades there have been three great buildups of stock market bubbles.

As markets climb higher and higher, average people, who were previously only vaguely aware that they had money in the stock market through their 401(k) plans, become more and more fascinated by ever-rising stock prices. They wonder if they should add more money. They often hold off because they think the market is sure to crash. When the market doesn’t crash, but still goes up, investors decide to put money into the market after all. When this happens, there’s often a steep rise, validating people’s decision to invest. However, this moment tends to mark the top of the bubble – and the bursting begins.

In the 1990s, bubbles grew around technology companies. The internet seemed to offer unlimited potential for these companies, and their prices rose to astronomical levels. After the 1990s tech bubble burst, a new one grew in the financial sector. This time, the bubble was fed by lax lending policies and a boom in real estate. This bubble famously burst in 2008.

In today’s market, people are drawn to cryptocurrencies and other digital assets. Just like with prior bubbles, there’s a firm reason for optimism. However, the frantic moves in prices – both up and down – have created a mania that makes cryptocurrency a potentially dangerous bubble. Regardless of how you feel about the potential for blockchain, the prospect of catastrophic losses (Bitcoin fell by 65% in one month in 2018) makes crypto unsuitable to most people nearing retirement. However, that won’t stop people from pouring money into cryptocurrency. Unfortunately, when the price falls, the average investor, betrayed by psychology, will stay invested until it’s far too late. With proper planning, you can avoid this fate.

The solution to emotional investing

To summarize the problem: Humans have a number of emotional blind spots or weaknesses, including confirmation bias, herd-mentality and a tendency to take more risk when they’re facing losses already.

Moving flip book of Understanding life insurance book  offer.

If our emotions are bad for us as investors, what can we do about it? We still need to make investments, after all. Plus, interest rates truly are terrible right now; the money for retirement has to come from somewhere.

Fortunately, knowing about our own biases and weaknesses can help us overcome them. If you’re aware that emotional investing is a prescription for disaster, that’s a great start. If you know about it, you can plan for it, and planning is the second key to avoiding the downsides of emotional investing.

You must have a plan. And, your plan must be created in a way that minimizes your ability to invest emotionally. For starters, you’ll want to find an advisor that’s not subject to emotional investing himself or herself. If an advisor recommends that you go all-in on the stock market to ride the momentum of the current bull market, you need to think twice.

Instead, make sure that you and your advisor are on the same page when it comes to asset allocation. This is the overall mix of your investments. You probably do want some stock market exposure, but be smart about it. One popular rule of thumb is the 100 minus your age rule. This rule states that your maximum allocation to stocks should be equal to 100 minus your current age. So, if you’re 55, you should have no more than 45% of your portfolio invested in stocks.

Regard this as a maximum, though. It’s OK to be a little over-cautious, because the consequences of large losses are so devastating especially when you’re near retirement age. In the table below, notice how much gain you need in order to recover from losses. And, this just returns you to where you started. For example, if you lose 40% of your portfolio value, you’ll need to earn 67% to make it back. But, you still haven’t made any actual gain; you’re just recouping what you’ve lost. Plus, how easy is it to make 67%? It will take a while, maybe more time than you have before you retire.

chart for loss and gain needed to recoup losses

So, you need to resist the urge to join the masses and get in on the highest-flying investment. Working with your advisor, you’ll map out a realistic strategy using sound asset allocation strategies. You’ll avoid the big loss. But, you still need to earn money for retirement and then generate income to live on in retirement. How can you do this without falling victim to emotional decision-making?

Consider products like indexed annuities and life insurance. These assets in some ways combine the best of both worlds for two key reasons:

  • They allow you to make stock market based interest on your money.
  • They protect you from market losses.

In other words, you can earn high interest on your funds when the markets do well, but, if the market rises too far, too fast and crashes, you’re protected. The worst you’ll do is earn zero interest for the year, but this is a lot better than those investors who chase performance and buy at the top of the market, just before a crash.

Even better news about indexed insurance products is that they can provide excellent income in your retirement years.

We already talked about how low interest rates are these days, and dividends on solid companies aren’t great, either. But, using the power of indexing with the guaranteed income feature of annuities can be a game-changer.

Annuities can be converted into streams of monthly income. When you do this, the insurance company guarantees a monthly payment to you for the rest of your life. It doesn’t matter how long you live, either; you’ll get the monthly income even if you live past 100. This relieves one of the major fears of retiree’s: out-living their savings.

Take emotion out of investing by having a solid plan

If you’re going to avoid the pitfalls of emotional investing, having a solid plan is key. This is especially true if you want to use some of the indexing products we talked about. While indexed annuities and life insurance can be wonderful tools. These kinds of products often include surrender periods, so if you decide to use them, make sure you’re committed to them for the long haul. But, if you choose them with the right plan in place, you can successfully avoid the perils of emotional investing. Plus, the long-term nature of these products can help you stick with your plan and avoid the temptations of emotional investing.

Alliance America can help

Alliance America is an insurance and financial services company dedicated to the art of personal financial planning. Our financial professionals can assist you in maximizing your retirement resources and achieving your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.

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