We just passed the one-year anniversary of the stock market high prior to the COVID-19 drop on February 19, 2020. It’s been a year of emotions running high. The pandemic changed the way we think about our finances. As unemployment rose, it’s possible some individuals felt the urge to make poor investment decisions in an attempt to cut their losses as the market dropped – a move that could potentially cause more harm than good in the financial long-term.
Behavioral finance examines the cause of these financial decisions, particularly the ways stress leads to financial self-sabotage. We will look at the ways emotion can impact financial decisions, then dive into four ways individuals can reduce concern and improve resolve during times of social and economic turmoil.
4 Ways to Keep Emotions Out of Financial Decision Making
Way #1: Understand Your Risk Tolerance
Just as it sounds, risk tolerance is your ability to tolerate the potential risk of a financial decision, typically an investment. In other words, if the market were to take a turn for the worse, your overall livelihood would not be at risk. This does not mean your investment will be lost, it could be the exact opposite. Rather, risk tolerance seeks to counteract the stress of investing and spending, reducing the likelihood that individuals will withdraw their investment during difficult times or overspend during exciting times.
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Way #2: Limit Investment Discussion
Markets never stop. New headlines are everywhere, every day. Friends, family, articles and the news will all discuss the market. But as a savvy investor, you can reduce emotional turmoil by limiting how often you engage in these interactions. This is not to say that you should not be informed. Rather, it is to avoid the immediate emotional responses that often lead to poor financial decisions because of reactionary media coverage and discussions with friends and family.
Way #3: Diversify Your Portfolio
Similar to risk tolerance, a diverse portfolio seeks to reduce the stress of investing by not placing all of your eggs in one basket. Instead, growth in one area can offset a setback in another, preventing the dramatic drops in portfolio value that often create the stress or excitement that leads to poor financial decisions.
Way #4: Understand Market Trends
There’s added fear for topics we don’t fully understand. Understanding a problem can often reduce the anxiety around it. This approach applies to investing as well. For example, Bear and Bull markets are cyclical in nature. Looking at a trend of the U.S. market may help investors better understand this. Knowing that markets are volatile, will rise and fall, and will sometimes move sideways is an important part of remaining calm during volatility. What varies is the duration of these peaks and valleys. It’s important to remember, however, that past performance is never a guarantee or indicator for future performance.
Being aware of trends can help reduce the emotional extremes of market fluctuations by understanding that investing can often mean focusing on long-term goals, not short-term peaks and valleys.
We’ve all had plenty of emotions over the last year. Our hope is that you haven’t let those emotions ruin any financial progress you had been making before the pandemic. Understanding your own emotions is crucial to making better financial decisions. We help our clients keep their emotions in check all the time. If you think you need to work with an advisor to help make better decisions, we’re here for you! You can click here to schedule an initial call with one of our team members. There is no cost or obligation.
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