Maintaining Emotional Control While Engaging in Financial Transactions

Maintaining Financial Transactions – If you ask the typical investor what factors they believe affect the success of their portfolio the most, you will likely hear answers such as the state of the economy as a whole, whether or not the stock market is experiencing a bull or bear market, and how their assets are allocated.

What they won’t typically mention, though, are their own feelings, personal preferences, and preconceived conceptions regarding money and investing. However, these and other psychological considerations can lead to investors making decisions that have a negative impact on the performance of their portfolio and that are counterproductive to the investors’ own best interests.

What exactly is meant by “behavioral finance” ?

The study of how diverse psychological elements influence the decision-making process of investors is known as the field of behavioral finance. It may be traced back more than 150 years to the release of the book Extraordinary Popular Delusions and the Madness of Crowds in 1841. This book examined the behavior of investors throughout various financial bubbles and panics and was the first step in tracing the origins of the phenomenon.

But the contemporary form of behavioral finance wasn’t formed until 1979, when psychologists Amos Tversky and Daniel Kahneman, both winners of the Nobel Prize in Economics, came up with prospect theory. This hypothesis is predicated on the supposition that investors place a different value on gains and losses and that the psychological impact of a loss is far more profound than the emotional impact of an equivalent gain. Loss aversion is another name for this psychological phenomenon.

Case studies in behavioral finance

Kahneman posed a question to his pupils in the form of a proposal to show them how things operate in the actual world. He would toss a coin, and if it came up heads, they’d have to fork over ten dollars. After that, he inquired of the pupils how much money they would need to win if the coin came up heads. In order for the majority of the students to participate in the wager, they demanded a payoff of $20, which was twice as much as they stood to lose.

To demonstrate that the consequences of prospect theory are not influenced by a person’s level of income, Kahneman presented an identical proposition to prosperous business executives, with the exception that they stood to lose $10,000 if the coin came up heads. However, in order to take the bet, they demanded a sum equal to twice the loss, which was $20,000.

This sensitivity to losing can manifest itself for investors in a variety of different ways.

For instance, many investors will not worry about the performance of their investment portfolio as long as it is increasing, and they will pay minimal attention to the stock market for extended periods of time, sometimes lasting for months or even years. When the market enters a period of volatility and uncertainty, however, those same investors, prompted by the psychological impact of losses in their portfolio, will panic and sell their assets – typically precisely around the time when the market bottoms out.

It’s possible that those same investors will refrain from buying back in when the market rebounds because they don’t want to pay greater prices than what they sold for or they’re afraid that if they do, the market will turn and collapse again. Therefore, they do nothing but observe from the sidelines as the market reaches new heights, having already reached its previous peaks.

It’s not hard to picture it happening. Consider the stock market investors who, out of fear of incurring further losses, liquidated their holdings on “Black Monday” in 1987, when the market experienced a 23% plunge. Or the early years of the new millennium, when the dot-com boom exploded. Or during the economic crisis that occurred in 2007. Or even more recently, in March 2020, when the S&P index experienced a decline of 34% as a result of the Covid-19 pandemic.

Eventually, the stock market recovered in each one of those situations, and while if past performance is no guarantee of future success, investors who cashed out when the market was at its lowest point missed out on the subsequent comeback.

Adjusting behavioral biases

Our relationship with money as well as the feelings that being in a financial bind evokes in us have been shaped and refined over the course of many years, and there is no simple way to “flip the switch” and modify them or make them go away.

There is no way to avoid knowing when the market is in a volatile period unless you plan to avoid all news and social media for the rest of your life. This could potentially cause you to make a hasty decision about your investments. Having set financial goals and using a “automated” system like dollar cost averaging can sometimes help minimize the impact of emotions on your investing. However, unless you plan to avoid all news and social media for the rest of your life, there is no way to avoid knowing when the market

It is in your best interest to seek the assistance of a competent and knowledgeable financial counselor. When you can’t be objective about your investments yourself, it’s helpful to have someone whose job it is to be. However, you should make sure that your financial advisor possesses both a disciplined investing strategy and the knowledge necessary to understand how critical it is to maintain that strategy even when things go rough.

Your financial advisor may have the same level of anxiety as the typical investor if they do not have a disciplined investment plan or if they do not have any experience navigating stormy markets. You have the ability to ask your advisor a variety of questions on their methodology or the techniques they employ when dealing with challenging markets. Please get in touch with us for a Portfolio Review if your financial advisor does not have a plan for the long-term management of your investments.

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