Ah, Money. The word leaves you with a positive or a negative feeling when you hear it. The feeling we get from money, and investing, has deep roots inside our emotions, although we may not understand why. Behavioral science explains why we make our investment decisions and how we emotionally react to them.
Behavioral science has become such an extensive study that there are now multiple sub-categories to it. Behavioral science is the science of 'choice' that explores emotional decisions, and behavioral finance studies why investors make the decisions they do.
Understanding emotional barriers to investing
Even when investors have information that should lead them toward good investment decisions, they don't always make the appropriate choice for their situation. That's where emotional barriers come in; our feelings about our investment decisions or lack of decision-making and how they make us feel. For example:
Risk tolerance measures of the degree of loss an investor is willing to endure within their portfolio. Market volatility, economic or political events, and regulatory or interest rate changes may affect an investor's portfolio and produce an emotional response, either positive or negative, in the investor.
Periods of market volatility are normal occurrences that may impact an investor emotionally regardless of the impact on their portfolio's performance. Risk tolerance assessments measure the investor's tolerance which aids in constructing a portfolio of strategies that produce positive returns with less volatility and appropriate emotional responses for the investor.
What are some behavioral barriers to investing?
Behavioral barriers include decisions we make due to what we observe in others, cultural beliefs, or an acceptance of our current financial situation and well-being. For example:
We see others' success or hear what they invest in and ‘mimic’ what they do. Herd investing can be both emotional and behavioral. Consider these examples:
- Our employer retirement plan is enough because we see the older generation that retired from the same job we have and think they are financially confident.
- We invest in a 'hot stock' because we watch TV or listen to a journalist, aka 'expert,' tell us we should.
- We invest in the same strategies our friends and co-workers use because they're financially secure.
Due to their beliefs, an investor may not accept professional advice, is mistrusting, doesn’t believe in investing, or the investor’s sex may determine the role they have in investment decisions and managing the household money. All these relate to cultural barriers if the investor follows their culture’s teaching about money, finances, and investing.
The emotional gap refers to investing decisions based on emotions such as anxiety, anger, fear, or excitement. Emotions are a key reason people do not make rational choices about when investing or the investment strategies they choose.
Making impulsive decisions during market volatility
Thoughtful planning can help investors feel more confident during market volatility and help circumvent impulsive decisions that may impact their portfolio negatively.
For example, selling and reinvesting or pulling out of the market during periods of volatility may result in losses that can't be recouped. Instead, wait for a market correction and reallocate, rebalance, continue investing, and follow your financial plan.
These barriers are typical and part of what makes each investor and their situation unique. The role of a financial professional has become even more critical in helping investors overcome behavioral and emotional barriers. They work to convince investors to make rational investment decisions and coach them away from destructive investing behaviors that may impact their financial independence now or in the future.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
This article was prepared by Fresh Finance.
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