Money can be an emotional topic. It can raise feelings of greed, fear, entitlement, or shame, among others. It is important to have emotions impact money in one stage of the investment process: when defining your goals. Here are a few examples:
- You expect to have great emotional suffering when your portfolio declines. This may lead you to have a greater allocation to low-volatility investments (CDs or bonds) than financially called for. It can make sense when done in the planning phase, and not during a deep decline.
- You may be stuck in the rat race for too long, and decide to take actions to live within your means. As a part of the solution, you are willing to accept short-term volatility for the ultimate goal of having sustainable spending relative to your assets.
Once you are done defining your goals, emotions can harm your investment results. Here are a few examples:
- Fear: After a big market crash, the media is very negative about the economy and stocks, and you are ready to sell stocks low, or stop investing new savings.
- Greed: After unusual gains in stocks, you decide to increase your stock allocation (buy high) beyond what you planned for originally.
- Familiarity Bias: You fall in love with a company, believe in their product and business plan, and decide to invest in it, without looking at valuations (price relative to book value or earnings) and other information.
The solution is easy to describe and tough [psychologically] to implement:
- When developing the plan, view its impact on your entire life, and balance the various risks. Accept that there is no safe investment – you simply choose which risk you can tolerate most. Examples of risks to account for are: a need for money during a big decline, panic selling during a decline, outliving your money, and inflation.
- Once the plan is developed, be cautious of making changes without changes in your personal circumstances. Unless you have very substantial assets relative to your expenses, and you don’t watch your investments frequently, you have to expect to feel uncomfortable with your investments at various points in life. The difference between success and failure can be the action you took against your interests under the emotional stress of an uncomfortable period.
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