Emotions can get the better of us when it comes to investing — particularly when financial markets get volatile.
Behavioral finance tells us we are inherently bad investors, prone to making decisions based on emotions rather than evidence and self-interest. Just as we are a bundle of biases and fears in our personal lives, we are in our investing lives, as well. We are afraid of losses, afraid of missing out on gains; we have biases toward consensus opinion and to recent experience.
"People are always emotional," said Tim Maurer, chief advisory officer for SignatureFD, which has offices in Atlanta and in Charlotte, North Carolina.
"We may think we're making rational decisions, but we're usually not," said Maurer, a certified financial planner who is also a member of the CNBC Financial Advisor Council. "They are more likely driven by emotions, and then we rationalize them."
Maurer, however, does not dismiss investors' emotional responses outright as behavior to be suppressed.
"The notion that these are faulty emotions and that we are responding inappropriately is false," he said. "We need to acknowledge that these emotions and fears exist and that they're not necessarily bad or good; they are neutral."
They do, however, need to be controlled. Emotions are not a sound basis for an investing strategy. Evidence continues to show that active investors underperform the market in the long run.
By the time most people react to events in the market, the market has already priced in the risk. Trying to time the ups and downs of financial asset prices rarely works to investors' advantage.
If you've got a plan in place, sit tight
But what if you're worried about a banking crisis? Or a still hawkish Federal Reserve or a possible recession on the horizon?
Like all good advisors, Maurer recommends that you hold tight. If investors follow a well-thought-out plan that balances their short- and long-term financial needs with their tolerance for risk, they'll be fine in the long run.
"The whole notion of a balanced portfolio is designed to accommodate our emotions and fears," Maurer said. "Otherwise, we should always invest in small value stocks which over the long run outperform everything else.
"Bond investments are an [emotional] accommodation," he added. "We own them so we can stay invested in stocks when times are tough."
Bias is an inclination of temperament or outlook, a personal and sometimes unreasoned judgment, according to the Merriam-Webster Dictionary. It is generally considered a negative trait and something to ideally overcome. In an investing context, however, biases are not always bad.
"Our biases are there for a reason," Maurer said. "When it feels like the market is at a top, it's not unnatural to think about changing your investment strategy."
"It might not be optimal, but it's not unnatural."
I'm a proponent of proactive management of allocations if someone's tolerance for risk has truly changed, but not if they just think banking stocks are overvalued.Tim Maurerchief advisory officer for SignatureFD
Some behavioral biases protect us.
While most Americans have a bias for a dollar today vs. a dollar in the future, the reverse can also have bad consequences.
"There are people who fund their future but don't fund their present in the form of emergency cash," Maurer said. "Then a job loss or a family emergency forces them to access retirement funds at an inopportune time."
"In other words, our bias for the present makes sense in that regard," he said.
Taking care of the present is particularly important for people in or near retirement.
"When people know they have enough cash to support themselves for seven to 12 years, they sleep better at night," he said. "They are more likely to look through stock market volatility and do a better job investing for their future."
Maurer has been a financial advisor for 25 years. He is a believer in diversified investment portfolios and sticking to a financial plan. However, if market volatility is a source of high anxiety for someone, he's not against making changes to a portfolio.
"I'm a proponent of proactive management of allocations if someone's tolerance for risk has truly changed, but not if they just think banking stocks are overvalued," he said. "When there's a risk that someone abandons a 60/40 [stock/bond] allocation for all cash, they may find solace in taking some action short of that extreme."
We are inherently emotional beings, and few things elicit more emotion than when we believe our investments are at risk. Acknowledge these emotions; don't deny them. It will give you more control over them and improve your financial decision-making, Maurer said.
Face those fears sooner rather than later.
"I have a bias towards proactivity, not reactivity," he said. "People need to accommodate their emotions in advance rather than them causing you to make snap decisions in difficult times."
