Five years ago, I published a piece titled “Animal Spirits,” which addressed the primal aspect of the human psyche that controls our need to survive, and how it impacts the decisions investors make.
My point then and now is that, like much of life, investing is about discipline—overriding those psychological instincts such as “fight or flight,” when we’re confronted with a perceived threat to our investments. The most common threat, of course, is a market downturn, particularly those steep and rapid declines like the bursting of the “tech bubble” in 2000 and the 2008–2009 economic meltdown triggered by the housing market crisis.
There is nothing “abnormal” about feeling a sense of panic when the value of your investments drops by half. A branch of study called behavioral finance attempts to measure and explain exactly how our psychology affects our investment decisions.
Of particular interest are investor reactions during times of market turmoil, when “herd behavior” can cause a rush by investors to unload dramatically devalued stocks. The urge to “do something,” is, “normal” and explicable under these circumstances. But, investors with the help of their advisors can employ strategies that make downturns more bearable, and thereby avoid behaviors that can wreak havoc on their portfolios and interfere with reaching their ultimate financial goals.
Another manifestation of the “animal spirit” that can affect an investor’s financial behavior is called heuristics. Heuristics means using and relying on past experience to guide our decisions in the present and future. In the investment arena, learning from history can be both good and bad.
Like much of life, investing is about discipline— overriding those psychological instincts such as “fight or flight.”
For example, if an investor learns during a market downturn that staying the course with a diversified portfolio comprised of solid, well-researched investments minimizes losses, he or she will believe in this approach. However, the bad side of heuristic behavior occurs when investors become so married to “doing what we have always done” that they close their minds not only to new opportunities, but changes that could avoid catastrophe.
There are some specific strategies to help investors control their “animal spirits.” Some strategies demand unwavering adherence, some require flexibility and a willingness to change; but all require one thing—discipline. For example:
Asset allocation—Dividing your assets among asset classes so they do not tilt too heavily to one asset category is a must. If any category takes a dive, or bursts a bubble, your portfolio should withstand the hit.
Rebalancing your portfolio—Periodically buying/selling assets to reflect trends and opportunities in the market as well as changes in one’s life situation is another must.
Dollar-cost averaging, or DCA—Requires the discipline of buying a particular investment on a regular schedule for the same dollar amount each time. The result: Buy more shares when the cost of a stock is down, and fewer when it’s at its peak.
Automatic savings—The main reason Social Security has worked (so far): Everyone donated, period, through good times and bad. You can do this on a personal level also.
Budgeted spending—Create a budget based on income and expenses and follow it; that goes for personal spending and investments, not just your business.
Sticking to a plan—This is the umbrella discipline for all the above strategies. No matter how flush you are, or how tight things get, tell your family, friends and business associates:
“That’s my plan and I’m sticking to it.”
1United States Department of Labor. FAQs: Conflicts of Interest Rulemaking–Protect Your Savings–U.S. Department of Labor.
This article was originally published in the August/September 2016 issue of Worth.