How To Invest Your Money: Part One – Psychology
This is the first of a four part series on how to invest your money. The main focus of this series of articles is to discuss the psychology of investing, how to get started, finding your strategy, and building your portfolio. I hope this can be a resource for many people who are looking for information on how to invest their money.
How To Invest Your Money: Psychology Of Investing
When asked how he made his fortune Warren Buffet said, “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”
Keeping your emotions in check while investing sounds easy enough in theory, but until you’ve witnessed your own investment portfolio gain or lose more than 20% of its value, you won’t know if you have the stomach for it.
While it’s true that the stock market has provided the best returns for long term investors, the returns do not come without risk.
Investment Profile and Risk Tolerance
When you first get started investing you will typically meet with a representative at your financial institution who will get you to fill out an investor profile to determine your risk profile and potential asset allocation strategy.
After determining your age, current net worth, investment knowledge, and main purpose of your portfolio, the questions will turn to your attitude towards risk. Examples of this risk assessment include questions about your willingness to accept losses in your portfolio, and your patience to withstand a market drop and recovery.
After completing the questionnaire, you will receive a score that will correspond to the type of investments that match your profile.
For a low risk tolerance individual, the recommendation will be to invest in GIC’s and other fixed income products.
For a medium risk tolerance, you might be steered towards a balanced growth or monthly income fund. And for the high risk tolerance folks, the advice will be to invest in any number of domestic or foreign equities.
Fear and Emotions
Many people can claim to have a high tolerance for risk when simply filling out a questionnaire. But until your own money is on the line, you just never know how you will react.
Look no further than the most recent market crash in 2008-2009, in which many investors lost up to 50% of their portfolio from the highs in September 2008 to the lows of March 2009. Tuning out the market noise and the negative news headlines is more difficult than it seems.
Fear and emotions can take control of you and even though many people believed they had the stomach to withstand the ups and downs of the market, most did not, and they ended up taking their losses, selling their equities and moving into safer investments like a high interest savings account, or GIC’s and bonds.
Instead of tuning out the noise they succumbed to fear and made an emotional and irrational decision. Now hindsight is 20-20, but the stock market has rebounded over the past two years while GIC’s and high interest savings accounts haven’t been paying more than 2% interest over that time.
Reality Check
If you’re willing to invest your money in the stock market you need to understand the risks involved. The stock market is not for short term savings goals, and it’s not a quick path to riches.
If you can’t handle the thought of losing money during the tough times of a bear market, then you should just stick with savings accounts and GIC’s.
But if you can practice the patience and discipline to stick with your strategy for the long term, and you can ignore all of the market and media noise that can play on your fear and emotions, then you stand a good chance of being a successful investor in the stock market.
In part two of this four part series on how to invest your money I will talk about how to get started with an investment portfolio, depending on your age, current financial situation and future goals.
Thanks for the great post! I think these questionnaires are a horrible barometer because they are influenced too much by emotions. Risk tolerance changes all the time. When markets are down, people are inclined to take less risk. when markets are up, they tend to want to take more risk. If you think about it, this is the opposite of what you are supposed to do – buy low, sell high! Risk tolerance is a moving benchmark influenced greatly by emotions. The key is to test risk capacity – http://www.wealthwebgurus.com/article/639/risk-tolerance-vs-risk-capacity.aspx
Thanks Jim, great point about risk and the markets. I know a lot of people who wanted to leverage into real estate a few years ago too, and then there are the margin accounts and Smith Manoeuvre’s that everyone got into at the tail end of the last bull market. Then they panic, sell and move into GIC’s or savings accounts while missing the market recovery. Not exactly what the text book tells us to do.
I think age has a lot to do with it too. I filled out that form when I was 19, of course all I had was growth on my mind!
One thing I’ve realized recently is that you don’t have to invest in stocks. Especially if you don’t understand them.
I’ve recently invested in something I know really well: personal finance blogs. I know the market, I know the value, and I know how much I can earn.
This is my example, but in every industry, people can find something they feel more comfortable investing in if stocks isn’t their cup of tea.
Good point Daniel, some people can do really well investing in things they are more interested and knowledgeable in. Art, precious metals, and other collectibles come to find.
Investing in personal finance blogs sounds like fun. For both our sakes I hope the future looks bright for this industry 🙂
I think most people don’t really know how they’ll react when their money is on the line… we all have some kind of bias when assessing our own profile and this could have negative consequences on our financial decisions.
A real, in depth self assessment should be required when starting to invest, so that we all really know what to do with our money. I think it would also be useful to show real life investment experiences one bad in order to illustrate what might happen.
And of course, never forget about diversifying our portfolio, in order to have limited exposure in one specific investment.
Thanks for your comment FP. I agree that some sort of case study exercise would be beneficial to show new investors some real life scenarios.
Quite an interesting and useful post, Echo! I liked that you emphasized emotions in this delicate context of money. I guess many of us don’t really know how we would react should our money be at risk. A lot of feelings and emotions reveal to us when we come against money issues. I think one should invest money only after a thorough self-knowledge and clear formulation of principles.
Many people also suffer simultaneously from overconfidence and under-estimation.
1) Overconfidence in their ability to ‘pick winners’, their tolerance for risk and their ability to execute actions consistently according to their trading plan.
2) They also suffer from under-estimating the knowledge required to be profitable, and the time and effort required to achieve long term financial success.
Keeping your emotions in check is without doubt the hardest thing about investing. When the market is closed and you make your investing decisions it’s easy. Once the market is open however, it’s like I have bipolar. Over confident and cocky when it goes up and suicidal when it goes down. All reason goes out the window.
Great article! I like how you talk about the importance of tuning out the negative noise when things get crazy. I remember in 2008 – 2009 when the market tanked. Everyone I worked with freaked out when they saw what was going on and sold what they had to invest in something with a little less risk. I did not because I was trying to think long term… but it is hard! Looking back, I think I did the right thing though. It pays to keep your cool in these situations.
“Many people can claim to have a high tolerance for risk when simply filling out a questionnaire”
That’s the issue I’ve always had with those questionnaires. It’s easy to imagine you’re willing to take risks when you’re not looking them in the face. But when things go sideways and you lose a bunch of money, I’ll bet a lot of those “risk takers” are suddenly a lot less tolerant 🙂
Great article and great quote by the man, the myth, the Oracle of Omaha. I have found it amazing how much mindset can sway an outcome. Now, I’m not talking about willing your investments to go up because that doesn’t work (I may have tried in my early days of investing) but putting forth an attitude for success. Thanks for the great read :).