COVID-19 Created the Perfect Case Study in Behavioral Finance: Here's What We Mean
The COVID-19 pandemic affected everyone, changing the way we live and creating concern for the future. Understandably, such sudden and massive change created ramifications for the market. As unemployment rose, it's possible some individuals felt the urge to make poor investment decisions in an attempt to cut their losses - a move that could potentially cause more harm than good in the financial long-term.
Behavioral finance examines the cause of these financial decisions, particularly the ways stress leads to financial self-sabotage. We will look at the ways emotion can impact financial decisions, then dive into four ways individuals can reduce concern and improve resolve during times of social and economic turmoil.
What Is Behavioral Finance?
Behavioral finance includes spending, investing, trading, financial planning, portfolio management and business commerce.1 Emotion is a driving force for many of these activities. But, unfortunately, this includes the way individuals respond to fluctuations in the market. Responses generally include over-spending or investing at times of excitement and adopting an “abandon ship” mentality when things are low. The good news is, there are several ways one can work to avoid these reactions. By limiting the sources of emotional extremes and obtaining a better understanding of market history, investors can better maintain their footing during times of market instability.
How to Avoid Emotional Decision-Making
Way #1: Understand Your Risk Tolerance
Just as it sounds, risk tolerance is your ability to tolerate the potential risk of a financial decision, typically an investment. In other words, if the market were to take a turn for the worse, your overall livelihood would not be at risk. This does not mean your investment will be lost, it could be the exact opposite. Rather, risk tolerance seeks to counteract the stress of investing and spending, reducing the likelihood that individuals will withdraw their investment during difficult times or overspend during exciting times.
Way #2: Limit Investment Discussion
Friends, family, articles and the news will all discuss the conditions of the market. But as a savvy investor, you can reduce emotional turmoil by limiting how often you engage in these interactions. This is not to say that you should not be informed. Rather, it is to avoid the immediate emotional responses that often lead to poor financial decisions as a result of reactionary media coverage and discussions with friends and family.
Way #3: Establish Portfolio Diversity
Similar to risk tolerance, a diverse portfolio seeks to reduce the stress of investing by not placing all of your eggs in one basket. Instead, growth in one area can offset a setback in another, preventing the dramatic drops in portfolio value that often create the stress or excitement that leads to poor financial decisions.
Way #4: Understand Market Trends
Understanding a problem can often reduce the anxiety around it. This approach applies to investing as well. For example, Bear and Bull markets are cyclical in nature. Looking at a trend of the U.S. market may help investors better understand this. The wave pattern we see in market trends tells us that whenever there has been a rise in the market, it eventually was followed by a drop and vice versa. What varies is the duration of these peaks and valleys. It’s important to remember, however, that past performance is never a guarantee or indicator for future performance.
Even if you do lose money on an investment, your investment advisor may advise you to stay in the market to make up for those losses - meaning that while your initial instinct may be to pull out, your financial partner may see the long-term benefit of staying put. As an example, you could very well regret selling when the market is lowest, only to miss the expected climb. Being aware of trends can help reduce the emotional extremes of market fluctuations by understanding that investing can often mean focusing on long-term goals, not short-term peaks and valleys.
Being aware of the impact of your emotional state on decision making can help you avoid the potentially harmful reactions that impact your financial health. When next examining your portfolio, consider these four tips to help you maintain a more stable footing.
This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.