When managing personal finances and investments, people frequently exhibit irrational behavior for different reasons. It doesn’t even take a month of stock market zigzag like we experienced in October to cause questionable decisions.
Everyone makes choices about money nearly every day – how to earn, spend, save, budget, invest, protect, and so on. Some are wise decisions. Some are harmful. Some decisions, particularly those regarding when and where to invest, might trade places from wise to harmful and back depending on the time evaluated.
Seemingly, if you can learn more about the cause and effect of your money decisions and the environment around you that leads you to those decisions, you will improve your financial security. But it is not easy to identify all behaviors as either rational or irrational while they occur. The stock market in October provided a convenient and timely case study and comparison to help explain why.
OCTOBER DOWNS AND UPS
In October, the S&P 500 Index of large U.S. stocks declined 5.6 percent through Oct. 15 and then gained 8+ percent from October 16-31. For someone who is sensitive to market moves, the swift early-month declines might have caused a flight response that would soon seem irrational given the rally the rest of the month.
If someone decided to sell mid-month (thinking that the decline may be the beginning of a deeper correction coming off an all-time market high) the behavior could be defined as loss aversion – one of many often irrational money behaviors.
Psychologically, people perceive losses (or declines in value in the context of an investment) as 2.5 times more powerful than gains of a similar size. Experience an investment decline of $1,000 and you feel 2.5 times as bad about the decline as you would feel good about a gain of $1,000. Therefore, most people are loss averse, and it’s clear why they may decide to sell when market prices decline. While loss aversion is often documented as an irrational tendency, let’s rewind back to October 2007 for an example of when this same behavior would have been viewed as timely clairvoyance.
October 9-19, 2007, the S&P 500 saw a quick decline of more than 4 percent, a situation similar to what early October 2014 presented. If the same investor who sold on October 15 this year, and looked irrational in hindsight for doing so, had cut back on stock market exposure on October 19, 2007, it would have been a brilliant move. It turned out that October 9, 2007 was a high point and financial apocalypse was in store for the next year and a half.
It’s situations like these that make it clear that, sometimes, irrational behaviors can lead to good outcomes. And sometimes, well trained “experts,” applying rational processes to their money management can be on the wrong side of the intended outcome, especially in the short term. It’s one of the things that makes investing fascinating, and at times, maddening.
UNDERSTAND YOUR TOLERANCE
Because investment markets are a complex system that can be both irrational and efficient, a great builder of wealth and detractor from it, the most important characteristic of a good investor is an understanding of their tolerance for risk. It’s important for everyone to have a well-defined perception of what risk actually means in terms of their financial security and their willpower to handle markets at their extremes when fear and greed influence decisions.
This evaluation of risk tolerance and comfort with market fluctuations is most meaningful when applied within the context of a written investment strategy that can serve as a foundation for long-term decisions. Your strategy – and your commitment to it – may benefit by stress testing the chosen strategy for how it may have performed in past crises. This form of rational planning may help avoid irrational decisions later, and understanding the potential risk may clarify why avoiding big mistakes is more important than trying to achieve market-beating performance.
Since we can’t predict outcomes when luck is involved, we have to make plans dependent on probabilities of outcomes. Rather than focusing on the size of expected returns, it’s helpful to know the probability that a chosen investment strategy can support a desired spending rate in retirement or make tuition payments, fund a wedding, cover health care costs, etc. It’s your broader financial plan that should drive the investment strategy rather than the opposite.
Ideally, when your plan is tied to your goals, you’ll have a better foundation for dealing with uncertainty and its effect on your emotions and decisions.