One of the first topics a good financial advisor always discusses with new clients is their financial and emotional tolerance for risk. Just as we need to know their financial capacity to take risks with their money, it is as important that we understand our clients’ emotional comfort level with investing. Do they recognize what role emotions play in their financial life? Are their decisions swayed by fear, greed, confidence, or regret? Some investors fall victim to greed, while others who experience a loss may succumb to fear and anxiety. Everyone wants to make money, but when prices begin to move against an investor, fear or anxiety can undermine logical thinking. Some people become emotionally paralyzed and are unable to think rationally while losses pile up. This fear of losing too much too soon can also make one jump out of the market too early. With extreme fear of loss, an investor might resort to irrational ways to overcome the anxiety which commonly leads to the exact opposite of what all investors should do - buy low and sell high. During times of volatile investment markets, ironically, some of the best opportunities emerge as the market gets close to the bottom, not when we feel the emotional rush of excitement when a market is on fire with golden promise and opportunity!
How to get your emotions under control
To succeed in investing, you’ve got to learn the skills to manage yourself and your emotions. Emotional neutrality, the concept of removing greed, fear, and other human emotions from financial or investment decisions as much as possible, is the key. You should only invest for logical, rational reasons, and never, for example, because your colleagues are buying in droves and making a killing (and especially not because some day traders banded together to tank a hedge fund). Most important but hard to follow: make sure that you do not get carried away with the crowd. A lot has been written about crowd behavior in the investment industry, but more attention is being paid to the phenomena of emotional contagion. As the term suggests, people can infect each other behaviorally. And, in investment matters, this can cost everyone a lot of money (remember the technology bubble of the late 1990s and the housing bubble of the mid-2000s?).
Beware of Contagion
In fact, history has shown that it is generally best to do what is diametrically opposite to what the crowd is doing. When the crowd is cheering and buying, look to sell; when it is panicking and selling, it is generally time to make your move and buy. Investment contagion frequently gets in the way of sound decision making and leads to irrational or imprudent behavior by preventing reasoned, logical evaluations of investment opportunities.
Getting Past Your Emotions – with Patience, Discipline, and Fortitude
Patience, discipline, and fortitude are the antidotes to emotional investing. Patience is a key trait for successful investors, as there is always the temptation to “get infected” by group behavior, which is often ruled by greed or fear. Being patient will help an investor through volatile markets because the long-term investment mindset will take the focus off the short-term volatility. Discipline is needed to ensure that one stays true to investment principles and philosophies and does not stray off the well-trodden path. Disciplined investors follow the plan they built, trusting that it was created to survive periods of volatility. To cultivate discipline, ignore the noise and the so-called “advice” bombarding us daily in the form of recommendations and forecasts. Fortitude is the “mental and emotional strength in facing difficulty, adversity, danger, or temptation.” This is probably the hardest emotional quality to foster, as a loss on paper can feel very real and very painful due to our natural aversion to loss. Having fortitude means being able to overcome the anguish that you may have made a poor decision and to soldier on even though the odds seem against you. Fortitude is a powerful trait, honed by many years of being in the market and getting used to the market’s manic swings. Having a good, neutral adviser is also great help. Objective, fee-only investment advisors can be invaluable partners in ensuring that you don’t get carried away or become careless in the face of peer pressure, media noise, volatile markets, greed, overconfidence, fear, and regret. A good adviser should keep you focused on what matters most: your endgame, reaching your financial goals by sticking to a well thought-out and disciplined investment plan.
