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Emotions can ruin your financial future. Here’s an example.
The late 70s and early 80s were times of high inflation and volatile markets—much like today. At the start of 1980, Tom decided to invest in the hottest mutual fund he could find: Fidelity Magellan. That year the fund produced an eye-popping 69% return. Its strong performance continued, but after a few years, Tom got nervous. He heard a lot of negative chatter on financial news channels and began reading headlines warning of “The Coming Crash.” He was afraid of losing what he’d made and decided to exit the market. That decision cost him a fortune!
If Tom had stayed invested throughout the decade, his returns would have exceeded 29% per year! By investing emotionally and moving in and out of the fund, he ended up earning a modest 7% per year. The long-term effect of acting on short-term emotion cost Tom big time.
WHY EMOTIONS CREATE PROBLEMS
Emotions evolved as rapid responses to immediate environmental threats and opportunities—to things that are potentially dangerous. It’s easy to witness emotions in other animals. Recently I was standing next to my cat, Victor, when he saw a dog nearby. In a fraction of a second, Victor’s tail tripled in diameter and his back arched in response to possible danger.
We have the same kind of physiological system that the cat does—a 'factory installed' system that’s designed to respond to immediate perceived threats. If there’s a difference between us and the cat, it’s that we don’t have tails: the outward expression of our emotions are better hidden. But the inward effects are very much the same. When Victor sees the dog, and when Tom hears that the markets are primed for a decline, the physiological response—and ultimately the behavior—is the same.
These emotions mostly happen involuntarily. This means they go on and off quickly, like a light switch. Their fleeting nature makes them poor tools for long-term decision making, including financial decisions. Successful investing requires long-term discipline. Financial decisions impact your life for more than a single moment in time, so they need a longer lead time. To accomplish your financial goals, you need to think beyond the moment. You need to think and act long-term, which is exactly the opposite of how emotion prompts you to act.
When Tom’s emotions kicked into high gear, he reacted by leaving the market, and his investment returns suffered.
If Tom had stayed invested for the entire decade he would have more than quadrupled his actual returns! That’s a high price to pay for failing to think financially.
Yet, without the right coaching, investors default to emotion. It’s impossible to totally tamp down your emotions, but you can still make better decisions by learning to think financially.
HOW TO MANAGE EMOTIONS AND THINK FINANCIALLY
Here are 5 essential skills for thinking financially and achieving financial success. Together, they counteract the effects of emotion by keeping you focused on your long-term goals.
- You need to formulate clear and realistic goals. What are your life goals? What’s your purpose for investing? Tom’s only goal was to realize high investment returns. The problem is that “high” is ambiguous. You can’t measure “high,” so you never know whether you’ve achieved the goal or whether you’re making progress toward it. Let’s contrast Tom with another investor: Alice. Alice has measurable goals: she wants to retire at age 67 and continue to enjoy life with 80% of her current income. Because she has a specific goal in mind, she can formulate a clear investment plan. She can also track her progress toward that goal. She knows that in some years her returns are going to be lower than expected, and in other years they’re going to be higher. Because she has a clear goal, she’s able to look past these momentary ups and downs and stay focused on the long- term. Unlike Tom who fled the market at the first downturn, Alice stayed the course, and ended up achieving her long-term goals. Measuring your current financial decisions against your long-term goals is the foundation of thinking financially. Our financial planning process keeps your purpose and long-term goals front and center.
- Don't confuse risk with risky. People sometimes confuse risk with risky. Risk has to do with probability. It’s the likelihood of something happening. Risk is everywhere; it’s built into the world. Risky, on the other hand, is something different entirely. It’s roughly synonymous with ‘dangerous’ or ‘perilous’. Robbing a bank is risky. So is driving your car 120mph. Investing involves risk, but it doesn’t have to be risky. Alice understands that the market is positive about 75% of the time. That means it’s likely to decline 25% of the time. To her, that’s a worthwhile tradeoff: she accepts some level of uncertainty in exchange for a far greater probability of a good outcome. Tom, by contrast, invested in the hottest mutual fund around. He thought the hotness of the fund provided a virtual guarantee that his portfolio would only go up, not down. He didn’t understand that all investments involves probabilities, not certainties. Alice, by contrast, understands that investing comes with no guarantees. Smart investing is a matter of balancing probabilities. It’s a matter of assessing risks and rewards. Tom’s approach to investing, on the other hand, was driven by fear of loss. He tried to escape from uncertainty in a field in which there are no hiding places. He thought that investing in a hot fund would insulate him from risk. But he was wrong, and he paid for it. As your financial advisors, we help you develop and maintain perspective about investing risk.
- Distinguish what you can control from what you can’t. The key to maintaining realistic investment expectations is to focus on what you can control. Tom had difficulty keeping his expectations realistic. Tom’s first year in Fidelity Magellan produced a 69% return. This early success made Tom overconfident. It made him feel as though he controlled short-term market returns. That feeling was an illusion. No one can control the stock market day-to-day. By contrast, Alice understands that there will be times when returns are high and other times when returns are low. She has no illusion about controlling short-term stock market returns. Focusing on what you control is necessary for thinking financially. We remind clients that savings, investment allocations, and behavior are the primary controllable components of financial life.
- Carry out actionable planning. Effective financial planning should be a springboard that propels you to take action. Ultimately, financial planning is about doing, not just knowing. It’s about taking steps to enact your planning—an essential part of thinking financially. We help our clients take action steps and put their planning strategies into motion. For example, our client Marty had difficulty generating the motivation to take action on his own, despite having a business background. We helped nudge him to move forward. Our financial planning reviews always include action steps so that you can keep making progress toward your goals.
- Make financial thinking a habit. Thinking financially is an ongoing cyclical process; it’s not “one and done.” It’s an active process that involves ongoing re-evaluation of your circumstances to ensure your investments continue to align with your long-term goals. It’s a process that fine-tunes your investing decisions as circumstances change. Financial planning is a bit like physical fitness. Becoming physically fit is an ongoing process of aligning your diet and exercise with your goals. Achieving financial fitness is the same: it’s a dynamic process that responds to changing conditions. You need to adjust your financial decisions against the backdrop of your present situation while remembering your risk, purpose, and expectations. Having the adroitness to tweak your planning decisions is part of thinking financially.
Thinking financially means that you understand how difficult it is to stay on track. That’s where we come in. We bring “dispassionate discipline” to financial planning and help you avoid big mistakes. Changing circumstances can trigger emotional responses that tempt you to abandon your investing philosophy. We’re here to help you think financially and stay on track toward your long-term goals.
Related: Imagine Your Money Outside the Lines