“First rule of business is never get emotional about stock, clouds the judgment.”
Gordon Gekko, from the movie Wall Street
The quote above is from the fictional character, Gordon Gekko from the legendary 1987 movie, Wall Street. The challenge he was alluding to is the fact that it’s impossible to have a completely impartial lens when making financial decisions. There are many reasons for this.
Firstly, it’s our money, we worked hard for it and we don’t want to make a mistake and lose it. I have observed marriages dissolve because of financial losses. It’s a big deal and a lot is at stake.
Secondly, we tell ourselves stories about money. These stories have been shaped over many years by our upbringing, culture and personal experiences. Stories like money is evil, money is a measure of success, it’s hard to make money from investing, money changes people, money will solve all my problems, money makes me feel safe and so on.
The sun is smaller than it looks
Have you ever taken a photo of a sunset or landmark and been surprised how small it looks in the photo compared to the naked eye? The reason is because our brains play a trick on us… it’s an optical illusion. Our brain makes us see something that’s not real. Here are some explanations why this happens – although it’s not important for this blog – I’m merely making the point that sometimes we see what we want to see. Our impression of “reality” is shaped by our beliefs.
My observations over the past 17 years
I agree with Gordon Gekko that emotions are rarely a useful human behaviour when it comes to making financial decisions. They distort our views and can cause us to make expensive mistakes. In my experience, emotions can cause a few common errors including:
- Overthinking – it might sound a bit perverse, but you can overthink financial decisions. The problem with overthinking is that you start to explore every possible outcome and add too much weight to outcomes that are very unlikely to occur – almost so remote that they do not really warrant any attention or consideration. This can cause people to jump at shadows.
- Blind to risk – sometimes we want something to be true so much that we irrationally ignore any evidence to the contrary. This often happens when people decide to invest in a certain asset. At that time, they almost have rose coloured glasses and can’t see any risks or flaws. This is a very risky mindset.
- Paralysed by the fear of making a mistake – this is particularly common for people closer to retirement. They know they need to have an investment strategy and they also know that they don’t have any room (time) for error. As a result, they feel so anxious about making a mistake that they find it very hard to see what might be in front of their eyes. Similarly, people that have lost a lot of money on past investments can also be unduly influenced by fear. They become overcautious – not recognising that their past mistakes were caused by breaching investment fundamentals. They have a high level of nervousness even when a prospective investment is fundamentally sound.
- Overconfidence – how can you expect to be an expert at something without acquiring many hours, weeks, months and years of experience? When it comes to finance, it is important to be consciously incompetente. don’t think you know everything. Because you only have to be a little wrong to completely ruin an investment. And often, mistakes are not obvious (to non-professionals) at the outset. Arrogance is the silent enemy of successful investing. If you are going to make a significant decision about money, why wouldn’t you seek advice from an expert? It is what you don’t know that will likely hurt you in the long run.
How to mitigate this risk
There are two ways you can avoid letting your emotions get in the way of your investment success. I would argue that you should employ a combination of both.
Rules-based approach to financial decision making
Employing a rules-based approach forces you to stick to the fundamentals of investment. Sticking to fundamentals is hardest when we are in an emotional state.
For example, we know that anger isn’t a response that serves us well, solves problems or gets results. So, it makes sense to choose a different response. That is easy to say but difficult to do when we are in a heightened emotional state i.e. angry! All of us get angry from time to time despite us knowing it doesn’t help. The interaction of emotions and finance is not different.
Therefore, setting out a number of rules and making a commit to stick to them will help you avoid making mistakes. These rules can be things like:
- I will save X dollars each month before spending money on anything else.
- I will never invest more than 1% of my wealth in a speculative stock.
- I will adopt a diversified asset allocation and not make large bets on sectors, industries or geographical markets.
- I will never invest in a residential property unless it possess all 18 attributes (see investment grade property checklist here for example).
- I will not make an investment based on subjective information. There must be overwhelming, objective historic data confirming expected investment returns.
Therefore, if you are feeling stressed, worried or over confident, you can refer to your rules to avoid you making a mistake. If the rules are sound, your decisions will be sound too, irrespective of your emotional state.
Engage an independent advisor or get a coach
Of course, I have a vested interest in saying this but that doesn’t make it any less true. The fact is that I don’t have the emotional baggage that my clients do. My lens is clear, unemotional, very pragmatic with a fanatical commitment to sticking to proven fundamentals. This serves my clients very well. If an advisor does nothing else other than stop you from making one or two expensive mistakes, they have probably gone a long way to creating value in excess of their fees.
If you don’t want to engage an advisor, get a trusted friend to hold you accountable for sticking to your rules and plans. Meeting with them periodically and share your goals and strategy. You can give each-other feedback. You can be your own board of advisors. One of your rules could be to never make an investment without your peer’s endorsement.
Its your money and that’s the problem
Its easy to see the wood from the trees when advising my clients because I’m not emotionally attached to their money. It can be a lot more difficult to make your financial decisions because as Gordon Gekko says, emotions “cloud your judgement”. Acknowledging this risk is the first step to avoiding its potential negative consequences.