What is it that makes us upset, angry, or even mad when we see losses in our portfolios?
Why do investors seem to always fall short of long-term average returns?
Why do we constantly feel the need to change our investments?
The short answer…we are wired that way!
Most individuals are planning YEARS in advance, whether for retirement, their children’s futures, a charity, or possibly a retirement home. The financial goals that we strive to achieve are abundant and the list could go on forever. Now, the great part about planning early is that you have YEARS of compounded returns to help generate wealth and expedite the time it takes to reach these goals. However, the unfortunate part of long-term planning is that it brings YEARS of opportunities for us to screw it up.
The past few months, I have been diving into dozens of books trying to further understand behavioral finance, how investors make good and bad decisions, and how to more effectively manage my own investments and financial plans. With every book I read, I find myself coming back to the same answer, my brain. He is the protagonist and antagonist in every story I tell. Whether it is stress, impulse decisions, fear, or worry, our brain is responsible for how we act. By learning to understand what part of my brain is driving at different times has really helped me gather my own thoughts and better realign my decisions to match my goals. I hope to take a few moments to outline what I’ve learned and seen if it can help you as well.
Now, I’m no brain expert, but from what I have learned so far, we can basically chop the brain into three (3) section: Rational, Emotional, and Instinctual.
The instinctual part is pretty straightforward, it’s how every person will attempt to dodge being punched in the face. However, the emotional and rational parts are fighting 24/7 for control over your decisions. When we interact in different environments, our brain reviews analyzes and confirms decisions about the scenario almost instantly. The question we have to ask ourselves is which side of the brain made the decision. Is our decision to sell out of our investment portfolio a logical and well-reasoned decision? Or are we basing our decision off a story, news article, or talking head (ie: our emotions)?
The emotional brain processes information in about 2 milliseconds. The rational brain processes information in about 500 milliseconds. Thats 250x longer!
Gary Oliver, Ph.D. – John Brown University
So the short answer is, we are all wired to make emotional, irrational decisions! This is true with our friends, families, co-workers, and especially our investments. With our emotional side working so much quicker than our rational side, we need a way to structure our decision-making process so we can allow our entire brain to fully process the decision. Emotions are the worst enemy of our investing, and the more we can control them the better. Don’t believe me? Believe DALBAR (a financial research firm).
My recommendation is pretty simple, sleep on it! If you can hold a decision to impulsively adjust your investments, you will drastically improve your investment returns over time. Taking a pause will allow your rational brain time to catch up and make sure you have logically thought through the decision. Taking a pause to gather incite from other individuals (ie: your financial advisor) is probably a stellar idea as well.
The average investor has only returned about 2% annually since 1997. Over that same time, stocks have averaged about 7.5% annually and even fixed income (aka. Bonds) have returned around 5%. One of the main reasons for this is poorly timed irrational decisions. Something hits a new high, we want to buy it. Something hits a new low, we want to sell it.
I would recommend holding on any impulse decisions for about 72 hours. You have spent your entire life saving and investing for some reason, so should a sporadic decision really alter your future?
If, after a few days, you still feel adamant about your decision, then at least you have taken enough time to completely talk it through. As a financial advisor, I spent the majority of my time walking clients through these impulses and trying to help them navigate and focus on the road ahead. It sounds bad, but we see the same mistakes made over and over again. If we mapped your emotional brain against the S&P 500 it would look something like this:
The last point I would make it simple. Our emotions normally cause us to abandon our investment process but we need to be sure to not emotionally make decisions to begin an investment process. Our logic and reasoning should direct how we deploy our capital and how we save for our future.