Poised for Success
Want to know how you can tackle the fears and euphoria of the market?
Here is a tip!
It all comes down to our choices when experiencing strong emotions.
When you think about your 401(k), IRA, or any other investment, what do you feel is the greatest threat to that investment? Perhaps you are thinking about the economy, administrations, inflation, or recessions? All of these are logical and appropriate things to consider. But let’s take a step back and look at things from a bit of a different perspective.
First, let’s review the role of “traditional finance” in making investment decisions. Modern Portfolio Theory, credited to American economist Harry Markowitz, is a widely accepted and methodical approach to investing. It is the bedrock of portfolio construction in today’s world. In summary, it involves the following:
Identifying your objective for the investment account (retirement goal, college savings goal, etc.)
Assigning a time horizon (how long will the money be invested to achieve your goal).
Determining your risk tolerance (how comfortable you are with accepting downside risk to achieve upside potential.)
Based upon the three elements above, developing an investment portfolio that is allocated between stocks and bonds appropriately and diversified to reduce risk.
This method is fundamental to a good investment. However, there is more to the story. An investor’s decisions throughout the lifecycle of an investment have a significant effect.
The term "behavioral finance" considers the impact of neuroscience (how our brains are wired) and psychology (our emotions and biases) on our ability to make good financial
decisions. Our brains are designed to respond emotionally first. We naturally feel before we can think when perceiving a threat (in this context, responding to market news and conditions). And we are prone to act impulsively or possibly resist change when we experience strong emotions. For example, when the market bearing down (or ramping up for that matter), there are a variety of things we do that can negatively impact our decision-making. Examples include heuristics (taking mental short cuts), framing effects (being influenced by how information is presented), and a variety of other biases.
Importantly, research in behavioral finance has revealed the single most important element in determining portfolio returns is saving and investing behavior. It is more important than asset allocation, security selection and market timing combined. (The next most important key to portfolio performance is asset allocation – NOT investment selection or market timing.) Investment selection and market timing are at the very bottom of the list!
Simply said, investing behavior has a
tremendous bearing on investment performance. Many investors underperform the market and hurt their portfolio values because of too much buying and selling – with good intentions, but oftentimes based on fear or greed, as they try timing the market.
In summary, it's helpful to realize that our brain and emotions can prevent us from making the best financial decisions when emotions are running strong. Yet, by paying attention to these tendencies, we can strive to make better financial decisions that will improve portfolio performance. Managing our emotions as investors will improve decision-making and help us to “stay the course” amid market noise and attention-grabbing headlines. Adherence to a well-developed plan that weathers the ups and downs of the market will do great things for your portfolio and win in the end!
by Philip Schmidt