Today’s podcast looks into the relationship between personal behavior and the portfolio. Investors are not always rational, have limits to their self-control and are influenced by their own biases. The team tackles this topic by discussing loss aversion, herd mentality and why having a financial plan (and sticking with it) is crucial to achieving long-term financial goals.
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“What’s the use of running if you’re not on the right road?” – German proverb
Today’s podcast looks into the relationship between personal behavior and the portfolio. It is age-old advice to “buy low, sell high,” but this mantra fails to take into account the range of emotions that one experiences, especially when markets get volatile. Buy low, sell high seems like a no brainer from an outside perspective, but when looking at the data, people appear to do the exact opposite. Stress and anxiety can cause investors to act irrationally. For example, when stocks decline and bonds go up, many will choose to sell off their ‘risky’ stocks and switch to ‘safer’ bonds. However, this results in bonds being purchased at their all-time highs, which completely disregards the “buy low, sell high” mantra. Understanding how to overcome these emotions will prove to result in a more rewarding and awaited outcome.
A key term that is often used when discussing behavior finance is loss aversion. This phrase describes how a consumer is more motivated to avoid potential losses, than the motivation behind the feeling of pleasure associated with gains. Loss aversion stems from the prospect theory introduced by Nobel Prize winners Daniel Kahneman and Amos Tversky in 1979, which determined a person feels twice as bad about a dollar that is lost, opposed to the joy felt with a dollar earned. This idea of avoiding losses can certainly lead to difficult decision making when it comes to the market, especially in uncertain times. The media plays a highly active role in relation to behavior finance, as they are known to sensationalize market performance, particularly when the market is down. The reason for doing this because of the average consumers tend to feed into headlines portraying mayhem, rather than uplifting/encouraging stories. Likewise, herd mentality is another factor which plays into an individual’s consumer behavior. When a friend or colleague pitches their current action plan, oftentimes the other person will follow in their footsteps, as it seems to be the safest thing to do. If it worked for them, it should work for me, right? It is evident that numerous outside and internal factors can affect one’s outlook and determine their investing behavior.
It is estimated that nearly 70% of investors do not have a financial plan. This lack of strategy or method to justify investment decisions is a recipe for failure. It is important to note that not every plan has to be complex or designed to provide a solution to any unexpected market event. In some cases, a simple plan will work just fine. There are numerous aspects that play into the development of a personal financial plan. These aspects include cash flow, client age, spending rate and volatility rate. Debatably, the most important factor when investing is determining the appropriate allocation of stocks and bonds. If the current allocation is resulting in negative returns, this will undoubtedly instill fear into the consumer, and can lead them to liquidate out of fear. However, by choosing to reallocate, rather than liquidate, there is still the possibility for the negative results to turn positive. Wiser Wealth has developed risk questionnaires that are used to identify a client’s risk tolerance, which helps determine how much they are willing, or not willing, to endure in volatile markets.
Aside from emotions, it is normal for portfolio changes to occur after a personal or lifestyle change. When a client has a baby or is forced into retirement early are two common scenarios for a portfolio update. At Wiser, we believe it is our responsibility to ensure each client’s plan is prepared to adapt to unexpected changes and endure market volatility. Transparency is a crucial part of this. It is important that our clients are informed and at ease when we encourage them to ‘weather a storm,’ even when it seems risky. In terms of portfolio management, our objective is to get the client from today to the age of 95 without running out of money. Ultimately, it comes down to the ability to align risk and return in order to achieve the client’s financial goals.