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Author Dr. William Bernstein, (How Millennials Can Get Rich Slowly, The Four Pillars of Investing, The Delusion of Crowds) says investing is half mathematics and half Shakespeare. That sounds about right because both parts contribute toward successful investing.
Many investors expend tremendous effort and energy trying to out-smart investing math. However, Bernstein points out that the Shakesphere half of investing is where you encounter your biggest obstacle, that person staring back in the mirror.
If you ignore the behavioral and emotional aspects of investing, you’re likely going to have a less than satisfactory investment experience.
The financial media rarely discusses the psychological components of investing, so little wonder that investors shrug off its importance. Instead, their focus is on the economy, interest rates, inflation, and all the other parts of investing that you can’t control.
Do you find the math part of financial decision-making more approachable than the behavioral part? My four decades of experience suggests this isn’t uncommon. However, if you’re thinking math will allow you to craft certainty out of an inherently uncertain investing framework, that’s another issue. Financial decisions in general and investing decisions specifically aren’t just math equations…there’s always an important human element as well.
Investing math is primarily about probability. That is, how likely something will happen. The weather forecast is a familiar example of probability. How likely your favorite football team will emerge victorious this week is yet another. Each of these examples contain some chance that an outcome other than what is probable can occur. That’s called uncertainty.
You can’t eliminate uncertainty, but you can improve your odds of success by recognizing both the math and behavioral parts of the investing equation. That’s where financial planning comes in. The planning process helps you build a framework for confronting uncertainty.
Let’s circle back to the Shakespeare half of investing. Your emotions can be very difficult to control, so it makes sense to ‘undershoot’ the level of risk that you think is appropriate. When you make portfolio allocation decisions, the rational part of your brain is at work. You want higher returns, and at that time, you are ok with higher levels of risk. Then something like 2008-09 happens and your emotions take over.
One of the central questions you need to answer is exactly who you are and what you are trying to accomplish. These questions will help you find an investment structure that you can stick with in good and bad times.
Having an investment mix that recognizes your emotional triggers is key. This is a form of risk management, acknowledging that unexpected events can happen, and setting your portfolio up to recognize that reality.
There isn’t a one-size-fits-all optimal portfolio allocation that works for everyone. What’s right for you and your goals, won’t work for others with a different emotional makeup and different aspirations.
Your investing timeframe, your understanding of probability, and your emotions all fold into your financial decisions. As Shakespeare wrote in Hamlet, “To thine own self be true.”
Related: What’s the Difference Between the News and Your Portfolio?