Last month I posted a piece encouraging people to pay attention to their money. This, I argued, was “the one thing” that could make a meaningful difference in peoples’ financial lives. It may strike my readers this month, therefore, as counter-intuitive when I suggest that over-vigilance of one’s investments might backfire. Let me explain.
I don’t mean that people should stick their heads in the sand. However, an interesting finding from the field of behavioral finance shows a discrepancy in how we perceive financial losses versus gains. The phenomenon of loss aversion states that, in respect to money, we experience loss disproportionately to gains.
Checking balances too frequently leads to worry
If I were to give you $100, you would probably feel pretty good about it. However, if you find a $100 ticket on your windshield, studies indicate that you feel about twice as bad about this loss as you felt good about receiving the same amount of money. In other words, the experience of the loss of a certain amount of money carries more emotional weight than the positive feelings associated with the gain of a similar amount. According to this theory, constantly checking your balances can have a negative effect on your overall confidence because you need several consecutive positive results to “recover” from the downward feelings caused by a single bad day.
Financial news can trigger “fight or flight”
An associated caveat is not to pay too much attention to the news. We hear “another bad day for stocks” and this adds fuel to the fire of our loss aversion. Fight-or-flight reactions may kick in, causing fear that our money and very wellbeing are threatened. In this emotional state of mind, we are more prone to selling stocks or trading too often when these actions may in fact be detrimental to the success of long-term goals.
Be careful comparing returns
Don’t pay too much attention to returns either, especially short-term returns. News that the stock market is up over a certain period of time may naturally prompt people to check their statements to see how they did. If the stock market is reported to be up by 10%, your actual returns will usually be up less than that, unless you own 100% stocks, and stocks that are comparable to the index being cited. Comparing your returns to this generalized percentage gain may be like comparing apples to oranges. A well-diversified portfolio will have different types of stocks as well as different types of bonds. A diverse portfolio can’t keep up with a single hot class of investments. The flip side of this is that if the stock index is down 10%, your portfolio should also go down less!
Seeking the best returns?
In our “never enough” culture, the emphasis on wanting to get the best returns possible can have unintended adverse consequences. A key fact in the quest for adequate retirement funds is that returns can only do so much. While returns are important, a basic rule of investing is it’s not how much you earn, but how much you keep. Not only does this relate to carefully weighing fees and taxes, but also keeping a sharp eye on how much you save. If you aren’t saving enough, you may be taking too much risk in order to have your money working as hard as it can. Risk is just that – you are taking a chance on reaching (or failing to reach) your retirement goals.
Paying attention to the wrong things?
While it is important to pay attention to your investments, be aware of how and where you are focusing that attention. Frequently checking the balances of your accounts could leave you feeling more anxious. The losses sting more than the gains fuel joy. You’re likely to be uneasy and to worry more about not having enough money. Likewise, paying too much attention to financial news contributes to these negative emotions. Don’t let the day-to-day ups and downs of the news undermine your long-term goals: staying in the game and staying invested; don’t do anything rash.
Avoid an extreme focus on returns as this can distract you from two things that matter more: monitoring how much money you keep (by aiming for low fees and managing your investments in a tax efficient way); and tracking how much you are saving. Good returns are unlikely to make up entirely for lack of adequate saving.
Paying the right kinds of attention to your investments is wise; paying too much attention to the wrong things can make you feel worse. If you are paying too much attention and need help re-focusing, give us a call.