By Lee Sherman
The more cynical among you immediately recognize that emotion can play an out-sized role in how successful you are as an investor. So much so that there’s even a term, risk tolerance for how you feel about acquiring and losing wealth that financial advisors use as a metric for the kinds of investments they recommend.
Some investment vehicles such as mutual funds are considered conservative and thus, “safe”. While others, like grabbing the horn of a high-flying unicorn are much riskier, and speculative, but also capable of inducing a euphoria with an almost illicit appeal. Where you fall on the spectrum between saving and spending is also emotion-driven. One man’s nest egg is another’s broken omelet. Together these aspects (and more) fall into an approach called behavioral finance.
That the stock market rises and falls based on a few clearly understood principles such as interest rates, mortgage rates, and which party currently occupies the white house is widely accepted among economists. But much of how the market operates is akin to black magic.
Behavioral Finance vs Traditional Finance
Traditionally, investors may be considered to be perfectly rational and expected to exercise a degree of self-control when it comes to how they handle their money. Practically speaking this means doing things like budgeting, not spending money on things you can’t afford, and picking blue-chip stocks to invest in. Behavioral finance, instead, treats investors as the human beings they are. It fully recognizes that they may act outside the confines of what seems to be rational or smart.
A risk tolerant investor is more likely to swing for the trees, placing an outsized bet on a hot company they were tipped off on or have a gut feel for rather than on mathematical calculations. They may look at a new and unproven technology such as crypto-currency as a fantastic opportunity, while others won’t touch it. Not only are they not in the least bit rational, they are also the victims of their own implicit or explicit biases. While some of the most successful investors take a more hands-off approach and let their brokers execute trades as they see fit, others have little to no such self-control.
Don’t be That Investor
Another aspect of behavioral finance that can be extremely disastrous, is that these biases get reinforced over time. After some initial success, you might become enamored of your own ability to pick losers and winners. While you might indeed have some Svengali like ability, we’re gonna come right out and say it, it’s more likely you just got lucky. One way to avoid becoming the victim of your own success, according to financial experts, is to try to maintain a balanced portfolio that tracks with a known index such as the S&P 500.
Remember, you have a financial advisor for a reason. This person can assess your risk tolerance and come up with a financial plan that is best suited to it. Above all, your financial advisor can help you avoid confirmation bias, the tendency for humans to prioritize information that supports one’s existing beliefs. This can lead to you becoming overly confident and will result in bad financial decisions. Your financial advisor provides that much needed outside perspective that is predicated on many years of investing experience.
Lee Sherman is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Lee is an experienced journalist and editor with over 30 years of expertise with a significant history of writing in the personal finance and technology arenas.