How to Stop Your Emotions From Overriding the Facts
Editor's note: The stress epidemic is dangerous – especially when it comes to money...
Using stop losses can help you cut down on your stress levels by limiting your losers. But that isn't the only way our decision-making ruins our finances and causes us stress...
Today's Masters Series is adapted from the December 2017 issue of Retirement Millionaire. In it, our colleague Dr. David "Doc" Eifrig shares a simple method to help you take your emotions out of investing. While some of the numbers and details in the essay may be out of date, Doc's message still rings just as true in today's market environment...
How to Stop Your Emotions From Overriding the Facts
I hear from folks today who "have a feeling" the market is at the top...
Subscribers have written incessantly in recent years to tell me I'm foolish to have any faith in the ongoing bull market.
The fear you feel isn't necessarily based on analysis of any stock or macroeconomic trend. It's based on seeing a high balance in their brokerage accounts and being worried about losing it.
While stock valuations are high, the underlying fundamentals in the economy are strong. Inflation remains low at 2.2%. Unemployment is down around 4.2%. And perhaps most important, growth is stable...
Despite all the reasons for optimism, subscribers continue to ask us "When is the crash coming?"
We tend to think that locking in gains is the smart move... but you should stick with quality businesses that are performing well.
Resist the urge to call a top. That fear of loss is crippling. Instead, look at the underlying fundamentals of a company and the economy.
Let logic influence your decisions, not emotions.
Emotions Also Affect Your Sense of Value
Along with being loss averse, humans are prone to an emotional bias called the "endowment effect." This phenomenon, also known as divestiture aversion, occurs when we place a higher value on something simply because we own it. (Remember that lottery-ticket experiment I told you about yesterday?)
Richard Thaler, a pioneer in the field who won a Nobel Prize for his work, loved to show this concept with coffee mugs.
He'd offer to sell folks a generic coffee mug with a university logo on it, and the average price people would be willing to pay was $2.50. However, if he gave the mugs out for free and then tried to buy them back from people, they'd demand an average of $5.25.
Once it becomes "your" mug, it becomes a lot more valuable to you. We demand unreasonably high prices to give away the things we own.
Investors do this all the time...
Think of it this way... Let's say you own shares of retail chain JC Penney (JCP) because you used to work there and received shares as a part of your annual bonus.
But your current portfolio consists of a mix of stocks that either pay a high dividend or have substantial growth potential.
JC Penney fits neither of those requirements. It hasn't paid a dividend in four years and its revenues are down 26% since 2012. And it's accumulated a colossal mountain of debt over the years...
But there are folks out there holding too much JC Penney stock because they value it more than a reasonable buyer would.
They've created a strange link between their identities and that stock.
One explanation is that the endowment effect increases your bargaining power when trading in small groups, giving you an evolutionary advantage. Therefore, we've all descended from ancestors with an endowment effect built into their brains.
Whatever the reason, it doesn't help us today. We've all got a drawer full of junk just like that coffee mug worth at most $2.50.
Let's purge the mugs from our portfolios.
A simple test can help you shake off the endowment effect: From our example above, let's say you own $5,000 of JCP stock. What if overnight that $5,000 in stock turned into $5,000 cash. Now you have the cash sitting in your brokerage account and no longer own any shares.
You have the choice to either repurchase shares of JCP for the exact same price or use that $5,000 to invest in another stock.
Most everyone would choose to invest that $5,000 elsewhere. Let's face it, the S&P 500 stock index includes probably 400 stocks you'd rather own than JC Penney. Even though when you owned the shares of JCP, you didn't want to sell and buy something else.
Nothing happened to JC Penney overnight... The only thing that changed is your possessions.
The next time you sit down to evaluate your portfolio, or anything you own for that matter, think about this...
Mentally clear out your portfolio. Imagine selling everything and going to cash. Then review every investment as if you were deciding to buy it again.
That's the way the market works, really. Everything you hold today, you essentially decide to "buy" anew each and every day. You'll do better to think that way as well.
If you had cash for your current stocks or possessions, would you use the cash to rebuy them or use it toward something else?
Another psychological condition hampers our ability to successfully manage our portfolios...
Don't Dig In, Dig Out
Similar to the endowment effect, this condition hinders us when we need to get rid of assets that aren't right for us. It also clouds our judgments when choosing investments.
It's called the "backfire effect."
We've all been in family arguments where one side of the family feels strongly about one topic and the other side feels the exact opposite.
And the more you attack your family member's idea, the more he digs in his heels and refuses to change his mind. All the charts, data, and studies in the world won't matter.
You see, when our beliefs are challenged with contradicting facts, we try and incorporate those facts in any possible way to strengthen our stance.
Turn on any news channel, and you'll see this in politics every day.
A 2016 study out of the University of Southern California showed it's more than just a belief system... Our brains respond as if we're being threatened.
Researchers took folks with strong political leanings and put them in an MRI machine. They scanned their brains as they were exposed to opposing arguments on popular political topics.
The MRI showed that a small part of their brains, the amygdala, lit up when facing counter arguments. Longtime subscribers to Retirement Millionaire know the amygdala. It's the fear center of the brain, and it's responsible for the "fight or flight" response to perceived threats.
And it turns out... that's how our brains process opposing viewpoints – as threats. It causes us to react the same way we would if we saw a polar bear charging at us.
The backfire effect is detrimental in investing and business. You may have seen it recently in your portfolio.
Again, it all comes back to controlling your emotions and not letting them override the facts and logic.
When you choose to invest in a stock, here's a simple thing you can do that will go a long way in your success...
Write down the date you're purchasing the stock, why you're buying, how long you plan to hold it for, and your goal from the purchase.
This may seem unnecessary, but it will help you down the road.
By writing down when and why you buy a stock, you can refer to it later when reviewing your positions. You can then look at your notes on all your stocks. If the reasons why you initially bought aren't true today, it's time to make adjustments.
Please stop here and try it... Write down your reasons for all your investments.
As others get stressed by their finances, you've learned this weekend how to avoid some of the most common traps investors face: loss aversion, the endowment effect, and the backfire effect. Awareness of these behaviors and the simple techniques of stop losses and goal writing will help you manage financial stress.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
Editor's note: By following Doc's advice, you can quickly eliminate some of the stress in your life. And if you're looking to go a step further, we urge you to check out what TradeSmith CEO Dr. Richard Smith and a handful of our industry's most prominent bulls and bears shared during the first-ever Bull vs. Bear Summit this week. Watch the replay here.