By Roberta L. Nestor
No matter how you look at it investing is an emotional experience. Investment experiences can be equated to a love and hate relationship. Love it when you are making money and hate it when losing. Fear and greed is another type of relationship that investors often have with markets. Fear of losing money means “get out” and greed means “put me back in”. Countless times investors have made comments about markets as if the market itself was a real, live, breathing thing.
Study after study shows that the majority of investors make investment decisions based on reactions of sudden market declines or, of late, geopolitical events such as Brexit, the recent US government shutdown, and on-going tariff talks. And, it’s not only negative news that brings investors to make rash decisions. After a few years of an upward trend investors want to get back in. The concept of buying low and selling high has no regard for investor emotions.
These emotions are real and “Behavioral Finance” is on a fast-track. It is the study of investor behavior and is designed to help investors and advisors better manage emotions when it comes to investing. We live in a time where more and more complex financial decisions are shifting increasingly from institutions to individuals. A solid example of the shift of investment decisions is the 401k; when companies offered traditionally pension plans, employees did not have to decide how to invest their funds. 401k plans shift that responsibility to the employee.
That shift of responsibility has not paid off for most investors. Dalbar is a company that has been producing the “Quantitative Analysis of Investor Behavior” for the past sixteen years. One of their more well-known studies is that of the average 401k investor versus the markets. It goes like this: Over the last 19 years from 1998-2017 the average equity fund investor earned only 2.6% annually over the 19-year period included in the study, compared to annualized inflation of 2.10% and the S&P 500 Index average annual return of 7.2%*.
2.60% versus 7.20%??? Why does this happen?
According to behavioral studies, as human beings, we generally have a stronger preference for avoiding losses than for making gains when evaluating the risks of an investment. Because of this behavioral tendency, we respond and react more quickly to the onset of negative events that could trigger painful losses in our portfolios than we do when faced with a similar likelihood that could lead to performance gains.
How can you avoid these emotional pitfalls? Work with a qualified financial advisor – someone who will listen to your fears but will remain the voice of reason. There is a cost to making emotional decisions and shown in the 401k study, emotional decisions can have a large impact on your retirement plan. An advisor will ask about your investment experiences and will craft a portfolio that is based on your individual risk tolerance, not that of the markets.
*All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance is no guarantee of future results. This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Investors should consult a tax preparer, professional tax advisor, and/or a lawyer.
Roberta L. Nestor is a financial advisor practicing at 491 New Haven Avenue, in Milford, CT offering retirement, long term care, investment and tax planning services. She also offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network – a member FINRA/SIPC and a Registered Investment Adviser. She can be reached at 203-876-8066 or email@example.com.