The GameStop story dominated the financial news cycles last month, and with good reason: it is a gripping narrative illustrating the drama of the stock market (and perhaps will have repercussions that could change fundamental aspects of investing). This story has passion, energy, and of course, winners and losers. How very fitting that one of the main characters in this story was named for the infamous hero who robbed the rich to feed the poor. Robinhood, the online brokerage company at the heart of this story, holds the belief (per their website) that the “financial system should be built to work for everyone,” but has perhaps inadvertently led many inexperienced investors to embrace the gamification of investing, which could have very real consequences for their finances. For many Wealth Advisors, this story also illuminates the worst aspects in an investor, bringing to light so many behavioral biases that will very likely hurt your portfolio in the long run. Yes, the GameStop story is very entertaining, but it is far more valuable as a cautionary tale for the prudent investor to check their emotions at the door when it comes to their portfolio.
Behavioral Finance
The field of Behavioral Finance focuses on how psychological influences can affect market outcomes and asserts that every investor has emotions and biases that can help, but more often hurt, their financial decisions. We all have behavioral biases (like herd mentality, loss aversion, and plain old fear), and these biases can come in handy at times. For example, loss aversion, or the idea that we fear losing more than we crave winning, may encourage us to continue paying for home and car insurance. However unlikely it is, the fear of losing our home in an earthquake or having our car stolen is enough for most of us to protect ourselves against worst-case scenarios. On the flip side of that coin, falling prey to loss aversion will hurt you if it prevents you from investing even a small fraction of your portfolio in stocks.
Disciplined, Evidence-Based Investing: The Solution for Emotional Investors
So how do investors avoid making financial decisions based on emotions? By understanding and accepting that your biases will sometimes get in the way and committing to a disciplined investing philosophy based on evidence. The goal of a disciplined investment strategy (sometimes referred to as “passive,” to differentiate it from an active strategy of frequent buying and selling stocks in an attempt to outperform the market) is to build wealth gradually, to start early and focus on your long-term financial health. You probably will never see a newspaper headline or CNN chyron flashing “Breaking News” about how much better a disciplined investment approach fares over an active one, but the evidence shows just that. One of the key takeaways from Morningstar’s August 2020 Active/Passive Barometer clearly illustrated that despite the theory that active funds generally handle market volatility better, this was not the case even during the market craziness of 2020. There are many differences between the two investing styles, but to sum up: evidence-based investors understand near-term market swings are unpredictable and they ignore the noise, while active investors believe they can successfully predict when and how to trade on breaking news. Active investors define success as outperforming others or making a lot of money quickly, while evidence-based investors define success as being able to comfortably fund their personal financial goals. The crux of the evidence-based approach is that these investors make decisions about their portfolios based on what they know to be true – not what they heard a rumor about or what their “gut” is telling them to do. Evidence-based investors depend on the research and data of financial scientists to give them a competitive advantage and build portfolios and financial plans that will withstand market volatility.
When Might Emotions Help?
As a Wealth Advisor with a focus on women and sustainable investing, I do advise clients to allow emotions to guide some decisions, namely those related to their values and how they align with their money. For so many of my clients, it is paramount that their portfolios reflect who they see themselves to be as people, not merely how they perceive their returns. Acknowledging your expectations for your portfolio and your overall investment experience will help you to create a financial plan and investment philosophy that will incorporate your values (and subsequently, your emotions) into your big, ambitious financial goals. The trick is to remember your biases, trust the evidence, and acknowledge your emotions without putting them in the driver’s seat. As human beings, we have access to an entire spectrum of emotions that exist because they served a purpose for humanity to evolve over many millennia. But however entertaining or dramatic stories of big losses or huge gains in the stock market are, let us always acknowledge that emotions left unchecked often prevent us from making our best financial decisions. Investors who allow their emotions to run the show end up buying high, selling low, and losing out. Disciplined investors buy low, sell high, and do not treat their investments like a game, but like what they truly are: their financial future.