Although there's been a lot of volatility and reasons to panic, financial markets are now closing near all-time highs. The collective optimism and ethic that compels people to work hard, innovate, collaborate and prosper continues to drive the economy forward. Nonetheless, it is only human to have emotional reactions to portfolio volatility, whether it be fear and anxiety to losses, or confidence and elation to gains.
Our decision-making processes employ emotional filters to process inputs from situational dynamics, and probability estimates to assess and predict outcomes. In short, we use our emotions as "shortcuts" to trim time from analysis and to make ourselves more comfortable — a process that has major pitfalls. Our individual "intrapsychic systems" — our patterns of thoughts and beliefs based on life experiences, current moods, personal affects and biases — are filters that profoundly alter the outcomes of our decisions. To seek to maximize wealth accumulation over our own life cycles and (especially) across generations, it is critical to seek an understanding of our intrapsychic systems, solve for them and manage them over time.
Our biases, and those of investment managers, programmers and business executives, will come into play even if we hand our money over to advisors or choose "set it and forget it" investment models. Traditional finance offers a wealth of intellectual property—ideas, theories, disciplines, frameworks and logic — that dictate how we should behave in order to maximize wealth over time, but they account for only half the equation.
Traditional finance assumes that cognitive biases play no role in the decision-making processes of human beings, as though we are zombies — apathetic about the most important decisions in our lives. But today's smart advisor understands that human beings are complex, emotional creatures who are actively engaged in their own financial management beyond status reports, right down to decision-making.
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Everyone falls into a behavioral finance category. What's yours? Self-awareness leads to positive results. The book "Behavioral Finance and Wealth Management" by Michael M. Pompian details the most common human investor types and associated personal finance-related biases. Can you identify yours?
Type: The Preserver. A passive investor type, Preservers tend to value financial security and wealth preservation far more than growth. They are generally highly risk-averse, and losses are much more painful to bear than gains are a joy to experience.
Bias: Loss aversion. Preservers tend to experience a lesser degree of satisfaction toward gains and a greater degree of dissatisfaction toward losses, even if the amounts gained and lost are equivalent. Research shows that people will more often choose to sell their winners and hold their losers, hoping they can recoup the investment over time, even though this may lead to more losses.
Strategy: Slow and steady. Because volatility causes emotional anxiety, Preservers should not invest aggressively regardless of age and time horizon because they might be unable to stick to their investment plans during periods of market volatility, a tendency that often leads to long-term losses. Preservers should employ less risky, slower growing investments and other methods, such as higher savings, to achieve their long-term goals.