Greensboro, NC -- How much do emotions and psychology play into your finances?
Matt Logan Of Matt Logan, Inc is talking money, emotions and psychology this week.
One of the principles of Behavioral Finance is herd behavior. This is when a person follows a group of people, even if what they are doing is irrational. The theories are that people desire to be part of a group and the perceived safety even if the person knows that they are wrong. A perfect example of this is the dot come bubble. People became over confident and expected irrational returns. Instead of staying diversified, they through caution to the wind and followed the herd to buy these tech stocks up, only to find their investments come crashing down in 2000 and 2001.
Overconfidence can be a huge detriment and is a part of financial . People are wired to believe that they have above average abilities. This is confidence. The problem comes when people become over confident and believe that they can be much smarter than the overall markets. These people are shown to conduct a lot more trades than less confident people and also tend to have much worse returns.
Hindsight is 20/20
There is also the whole "hindsight is 20/20" theory. After an event like a market crash, a person will think that there were obvious signs that they should have been able to predict the outcome. The reality is that you can never predict the top and the bottom of the market. This hindsight bias has people pull their funds out of their investments and think that they are seeing signs of a previous financial situation.
Overreaction is also a part of investors behavior and the news media actually you may even get a small part of the blame. Well, not this show but the onset of the 24 hour financial news media has not helped this part of investors behavior. The way to make money with your investments is to buy at a low price and sell at a high price. While it is easy to say this, person's instinct is many times to do the exact opposite. For instance, when the stock market was on a run during the technology boom of the late 90's, people became over confident. They thought that returns in the market of well over 20% were the new norm and they expected that, so they threw risk to the side. If we look at what happened in 2008, when the whole world was ending, that was the best time to be investing in the stock market but many people were moving to cash. Overreacting with fear and greed are behaviors that can ruin an investor's returns. Many times I have do it yourself investors come to me after an overreaction where they lost a lot of money.
There are ways to avoid emotions becoming a problem with your investing. I have found that successful investors focus on the process and the long term. There is no quick fix to building wealth. The goal is to build out a long term plan and a process on how reviews are done and decisions are made. This can go a long way to curb short term, emotional investing mistakes. Many times, I will work with an investor to create an investment policy statement that fits their emotional investing needs. This way, we can refer to it and be sure that we are staying on track for the long haul. You are lucky to live in an area where there are so many qualified financial planners. Working with an experienced and credentialed advisor can also help by providing a voice of reason and help curb overreaction.