Fear of the Unknown Clouds Investment Decisions

Fear of the unknown, doomsday scenarios and ultimately "losing it all" drives a smattering of investors to make emotional decisions on financial matters.

Given that investors are bombarded by 24/7 news loops and market advice coming from every possible avenue, investment professionals say emotions during the investment process may be beyond your control, often genetically predetermined or manifested during childhood.

People are most likely to make decisions about their investments based on unique emotional responses shaped by their early life experiences, including the "imperfect love" a child received from their parents; childhood events that featured danger, threat or loss; the influence of key authority figures in a young child's life; family values and culture, and more, explains Chris White, seasoned investment counselor and author of Working with the Emotional Advisor: Financial Psychology for Wealth Managers.

"I've counseled individuals for 25 years and noticed there is a huge sensitivity to loss, whether anticipated or actual, which can be devastating," White says. "I find this especially true during bear markets, such as what the country experienced in 2008. Loss is twice as painful as the satisfaction felt during a gain, an emotion first derived in childhood. As a child, you experience this perfect love and are the center of your parents' universe, until suddenly you get a little older and discover this is not exactly the case. This realization is especially devastating to a child, and how the child reacts and rebuilds following this loss ultimately determines what we eventually become."

White describes three personality types that result from childhood experiences: fixer, survivor or protector, with each type displaying certain behaviors and motivations. For instance fixers like to be in control of social situations and are charming and energetic. Survivors turn to language and tend to be valiant and champions of lost causes. Protectors divert greatly from both the fixer and survivor by being more of a guardian to others with the goal of caring for others.

How Emotions Dictate Investment Decisions

"Although we like to tell investors to try to keep emotion out of investing, because we are human there will always be an emotional component to our investment decision making," says Robert Stammers, director with investor engagement of the CFA Institute. "The trick is to try to minimize it to the greatest extent possible."

Perhaps the greatest emotional hurdle for investors is that of fear - fear of the unknown, the uncertain, explains Jay Mooreland, MS, CFP, founder of The Emotional Investor. "The brain detests uncertainty," he says. "Many have said 'just tell me the news, I don't care if it's good or bad, I just need to know.' Or in other words, the not knowing is the worst part.  And investing is fraught with uncertainty."

Investors will often try to reconcile whether this 10% correction is a great buying opportunity or the first step to a brutal bear market, for instance. "We don't know if we will reach our goals or have to adjust our lifestyle," Mooreland adds. "Investors can generally quantify a downside risk they are comfortable with, such as I can handle a 20% loss."

But the real challenge lies in the uncertainty.  "When the market is down 15%, analysts are slashing their forecasts, the news is negative and we feel awful, we don't know if the market will stop at 20%, go just beyond it to 21% before it hits bottom or down 50% or more," Mooreland reasons. "That uncertainty can oftentimes trigger our amygdala, which puts us in survival mode. And how do you survive when experiencing market losses that may get worse?  You get to safety…and when that comes to investing in stocks it means out of stocks and into cash."

Greed also comes into play, especially when mixed with fear, which often cause many to make decisions that are commonly incorrect in order to try and stem losses or to try to extend potential gains, Stammers adds.

"Buying high and selling low, the absolute opposite of investment objective often stems from these emotions," he says. "An example of this would be an investor that follows the crowd and tries to take advantage of the potential upside of a 'hot' security that has most of the upside already priced in.  That security's price starts to fall towards a historic average and now the investor fearing it may fall even farther and in attempt to curtail losses sells at less than the purchase price."

Can You Wrangle Emotions Under Control?

White says although once your childhood-based trait is ingrained into your personality, you can find pragmatic ways to make peace with those qualities and make smart money decisions.

"When you become overwhelmed or in the grips of emotion, stop and breathe," he says. "Know thyself, understand your personality type and the areas of strength and weakness. For instance, protectors will get into that deep, dark zone where the investor is feeling powerless and terrified. When you feel that emotion bubble up acknowledge what is happening and take a step toward being assertive, essentially using the bad energy and transforming it into something positive."

Practicing skepticism can also help too, Mooreland adds. "Research has shown that expert forecasts are seldom accurate, but often confident," Mooreland says. "Are we sure we want to follow that forecast? Is this forecast part of the 50% that will be right or the 50% that will be wrong?"

Investors can also take specific steps toward reducing the emotional impact on investment decision-making, Stammers offers:

*Increase your investment time horizon. Investing is a marathon and not a sprint.  When making decisions choose investments and investment strategies using a long-term lens. This will help investors weather some of the stress that comes with price volatility. It also gives investors the ability to assess performance over time, as well as, their investments ability to achieve long-term objectives. 

*Using dollar-cost-averaging, investors purchase securities using an equal amounts of dollars at regular predetermined intervals. This means more of a security is purchased when prices are low and less when prices rise. It removes much of the periodic decision-making and the temptation to time the market. It is also a long-term strategy that works during most market conditions.

*Diversification can also help reduce the stress of investing and let people sleep at night even when the market is in turmoil.  By investing in various asset classes and securities of various companies and industries that are geographically diverse, portfolios gain downside protection and a reduction in volatility during a variety of market scenarios.

*Invest with others. One of the ways investment advisors help their clients is by reducing the impact of emotion on decision-making.  By developing investment strategies together and evaluating those strategies together, investors are less likely to make knee jerk or impulsive decisions based on emotion.  Advisors can also be critical in keeping clients invested and on course when market turmoil make investors have second thoughts. Partnering with another person can also reduce behavioral biases and impulsive or irrational decisions.  Couples, friends, family, and investment clubs have a built-in sounding board to remind themselves about the rational for strategies and previously made decisions.

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