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Managing Your Response to Behavioral Biases

In the investment business terrain, there truly is no such phenomenon as a “sure thing,” and this is the reason our goals-based planning method takes into account the natural unpredictability of the market. In order to arrive at a safe middle ground, our strategy endeavors to invest assets in a way that even the worst of market situations have a less than total effect on any one portfolio. While there is no guarantee, prudent and science-based investing can help our clients weather the storm during market declines and benefit from the growth during periods of market upticks.

Human nature being what it is, however, we anticipate the anxiety that can lead clients to respond hastily during market corrections. Unfortunately, these premature panic responses can jeopardize a long term strategy, and significantly hurt a portfolio.

Behavioral biases can negatively affect our financial decisions, but there are ways to harness the power of optimism and manage your responses in a positive, confident manner, despite the inevitable pressures you may face financially over the course of your life.

The following is a demonstration of how a pragmatic approach to managing your behavioral biases can function to prevent your negative auto-responses during times when your confidence in your finances is strained.

1. Inciting Event

In stressful financial situations, it is important to look beyond prevalent emotional turbulence to zero in on the one event that directly initiated the incident. You could make a small checklist of all possible causative factors:

  • Job security concerns. Yes/No
  • Investments health worries. Yes /No
  • News of a sudden downturn in the market. Yes/No

Oh, that’s a yes, right? Fine, we can now progress along that line of thought.

2. Fears

When the market behaves in an unpredictable and negative manner, it can rouse all the negative preconceptions we harbored deep inside ourselves all along. It could be difficult not to succumb to concerns that it will not recover in good time or that the decision to invest was a poor one in the first place. It can be unnerving when the thought crosses our minds that our financial bedrock is quickly becoming quicksand.

During this stage, it is important to understand where those fears are coming from? Is there a lingering phobia resultant from stories you may have heard about past economic downturns, for example, the most recent and still very tender to those who experienced deep losses, the Great Recession of 2007-2008.[i] It could also be because a close friend or family member has suffered a hard knock from some investment that went south. Whatever the cause, the sooner you are able to accurately identify it as the underlying reason for your fears, the sooner you can live free of its debilitating effects.

3. Fallouts

When you are led by anxiety and fear in the making of crucial decisions regarding your investments, especially in a slump, you may well be making some of the worst financial choices possible. This is because your first and overriding logic is to “cut your losses” and run, salvaging all you can from what you deem a bad situation.

However, selling short during a low point in the market has traditionally almost always resulted in a loss in the long term. How then can you see a bird’s eye view of the situation?

4. Fight back

Logic over emotion is what is needed at this point. You will need to examine the prevailing circumstance with cold logic, balancing your fears against facts and precedent.

One thing we have established time and again is that, historically, the natural propensity of the market is to be bullish and keep going up in the long term. At present, robust growth is the case across popular financial indexes like the Nasdaq Composite, the S&P 500 and the Dow Jones. From time to time, these indexes will drop some points, which may lead to a nervous jerk as we imagine how much we lost.

You must understand that the proper way to look at such adjustments is in the light of the percentage of total volume. So, if there is a big drop of 1000 pts, look at it in terms of percentage instead of points.  Currently, a drop of 1000 points in the DJIA is roughly 3.5%. In order for it to be considered a correction we would need to see at least a 10% decline and the bear market doesn’t rear its head until we reach 20%.[ii]

In addition to avoiding knee jerk reactions to market dips, be wary of supposed “market timing” schemes, which mainly are not effective. The strategy we traditionally favor has been diversification, asset allocation that is appropriate for your level of risk and focuses on the long-term progress toward your goals.

If a study of the past has taught one thing, it has been that a long-term, solid strategy will beat a reactionary approach to every movement of the market every time. Therefore, results must be looked at long term, and with the knowledge that the losses suffered in the short term are just that, short term, and will likely have little effect on your long-term outcomes.

5. Reinvigorated 

It works to a great degree to juxtapose what you feel emotionally with the facts of the matter. This exercise will usually result in a positive and healthy mental state. We know of course that the reality of a market correction can often cloud all the theories and cause anxiety, especially the closer you are to retirement. This is why we encourage that you come in to talk to us every time you need to do this. We are always happy to go through our strategy with you, and hopefully, leave you as confident in our experience as we are in your future financial well-being.

Paces Ferry Wealth Advisors, LLC is a registered investment advisor with the U.S. Securities and Exchange Commission (“SEC”).  This material is intended for informational purposes only. It should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney or tax advisor.