When the stock market plummeted in 2008, did you promptly shift all your stock investments to bonds? Or did you drain your savings accounts and money market accounts, fearing your bank may collapse? An emotional response can be the downfall of many an investor. "It puts [investors] in the position of making the wrong decision," says Helyn Bolanis, president and founder of Parlan Financial. For example, selling stocks after a crash is almost never a good idea since it virtually assures investors will lock in their loss and miss any rebound. Meanwhile, pulling money from deposit accounts such as savings accounts, money market accounts and CDs because of a financial crisis overlooks that FDIC insurance protects individuals from losses (up to a cap) in the event a bank fails.
Science says emotions and investments don't mix
A 2005 study published by the Stanford Graduate School of Business demonstrated that fear can lead individuals to make poor choices. The study gave participants $20 and asked them to play in a 20-round gambling game. For each round, they could spend a dollar on a coin toss. If they won the toss, they would gain $2.50. If they lost, they forfeited the $1 they spent to play. Each round, participants were also given the option not to play. Although it financially made sense to play in every round, the Stanford researchers found participants became more cautious about playing as the game progressed, particularly when they lost the coin toss in previous rounds. Interestingly, researchers separated participants into two groups: One group consisted of individuals who had experienced damage in the part of the brain that regulates emotions. On average, participants with normal brain function bet on 58 percent of the rounds while those experiencing brain damage bid on 84 percent of the rounds. The second group came out on top in terms of money, walking away from the game with an average of $25.70. Those with normal brain function ended with an average of only $22.80.
How to avoid an emotional response
To make smart, rather than emotional, decisions about your money, Bolanis says you need to write out an action plan that outlines when and how you will react to the inevitable ups and downs that come with investing.