Behavioral finance studies peoples’ psychological tendencies when it comes to financial decision-making. A big part of this research focuses on investing mistakes. For the everyday investor, having a greater understanding of psychology can help you to break bad habits and thought patterns.
What makes our usual financial psychology dangerous is that it comes so naturally to us. How many times have you thought, “Every time I buy an investment, it only goes straight down”? Have you ever made an investment decision based on what you were hearing about the next big thing? It’s easy to fall into these types of patterns because they’re a part of our psychology. The key is to try to manage your financial emotions by resetting your mind.
Stepping back and looking at your investment behavior with a clear mind can be really difficult, as human nature makes us want to do the opposite. But in order to be a better investor you need to let go of your behavioral tendencies and think about investing without the distraction of emotions. Push that reset button!
For example, do you have investments that didn’t really work out that you’ve been holding onto for several years? Are you waiting for them to rebound because it’s too painful to take the loss? What about your portfolio – have you been putting off rolling over your 401(k) to an IRA or avoiding looking at your holdings due to market volatility? While it’s difficult to do, in situations like these you need to realize that you’re making the mistake of comparing your portfolio value today to what it was worth at its highest value. This value is no longer relevant: you need to make a decision based on today, not yesterday. To help clear your mind, ask yourself this question: If your entire account were in cash, would you make the same investments as you already have in your portfolio? If not, it’s time to push the reset button and make some tough choices.
You can help to avoid these situations by remembering that fear and greed are the two strongest psychological forces in investing. Know your exit points before you buy. It’s extremely easy to get greedy when investments go up and to panic when they go down. By having clearly defined boundaries, you can help prevent your emotions from clouding your decision-making.
In general, I believe that the best way to prevent human nature from taking over the investment process is to build a long term, actively managed, diversified portfolio. Active management can help focus your portfolio on the future, rather than the past, and diversification is consistently the best way to reduce the volatility in your accounts.
Taking these steps to rein in your emotions will help you adhere to an investment strategy without succumbing to short term volatility. Remember to think about what you would invest in today, define and stick with your exit points, and consider active management as a way to keep your portfolio current. Finally, remember to diversify to combat volatility!
If you are seeking detailed information about rolling over your 401(k) or about managing your IRA, I highly suggest downloading my free eBook, “10 Tips You Need to Know About Your IRA Rollover”. This short book is packed with critical information that will help you make the right decisions about your retirement savings.
Written by Bradford Pine
Bradford Pine Wealth Group – New York City Financial Advisors
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