How to keep your emotions from affecting important financial decisions.

People are typically great planners when it comes to life’s “fun activities.” We ponder vacations months in advance, have no trouble putting together birthday and anniversary party “to do” lists, and easily imagine how we’ll spend our retirement years decades before we call it quits. But when it comes to organizing our financial lives, the energy to plan sometimes seems to vanish into thin air. It’s a task many people procrastinate over or avoid altogether.

The tendency to postpone important decisions turns out to be entirely human. For the last 30 years, researchers in behavioral economics have studied how people make critical decisions. Using insight from both psychology and economics, they’ve determined that our emotions play an enormous role in the choices we make about all types of issues—including money and investing. While classical economics assumes that individuals act rationally and in their own self interest, behavioral economics says people often act irrationally—and sometimes against their own self interest—because they fall into relatively predictable psychological traps.

The good news: You don’t have to surrender to the emotional responses and psychological traps that may hinder sound, rational financial decisions. Understanding a few basic behavioral principles can provide insight and give you the information you need to develop strategies for making intelligent saving and investing choices.

The key, says Eric Gold, vice president of behavioral economics at Fidelity Investments, is to address your own emotions about investing, at a pace that feels comfortable. “Don’t feel you have to figure out everything all at once,” he says. “Simply reading this article can be a step in the right direction."

Understanding the fear factor

Over the last few years, investors have witnessed the decline of the housing market, the expansion of the subprime mortgage crisis, the collapse of Lehman Brothers, a global recession, and historic losses in the stock market (which subsequently experienced a significant recovery). These events fundamentally changed the way many investors view the markets and the economy at large.

“Before the turmoil, we weren’t ever sure what was going to happen in the markets, but we knew what the options and probabilities were,” Gold says. “That’s uncertainty—you know the market can go up and down, and you understand that there’s a certain amount of volatility.”

Gold says many investors’ attitudes today are characterized instead by ambiguity: They don’t know even what the possible outcomes may be, let alone the probability that they might occur. Without a familiar context for financial decision making, it’s easy to become emotionally paralyzed.

The difference between uncertainty and ambiguity may sound like little more than semantics. But neuroimaging studies have found that uncertain and ambiguous situations actually trigger different parts of the brain.¹ “If you’re not sure how you feel about the global financial system, you’re not going to feel as confident about investing,” says Gold. “That’s one implication.”

What’s more, humans have a well-documented aversion to losses. In fact, studies suggest that the negative feeling produced by losing something is twice as powerful as the positive sensation of gaining the same thing.² And loss aversion creates inertia, meaning you don’t want to risk losing any of what you have, so you simply stay put, even if that means forgoing an opportunity for significant gains. Combine these factors with the human preference for the status quo, and you can see why procrastination is so alluring.

The consequences of doing nothing

Letting your investments slide is the path of least resistance—but it won’t give you the best chance to reach your financial goals. “You may feel that you’re avoiding having to make a decision,” says Gold. “But, in fact, you are making a decision: You’re choosing to invest but not being an active participant.” That’s not a recipe for success. Indeed, there may be several compelling reasons to move away from the status quo—not least of which is the fact that the world changes over time. If your portfolio doesn’t change along with it, you may find yourself ill equipped to handle financial changes. Consider the following factors:

• The market’s impact on your portfolio. Ideally, when you began investing—whether in a workplace retirement savings plan, an IRA, or a taxable account—you chose a particular asset allocation that you felt was appropriate for your financial needs, based on your goals, time horizon, financial situation, and tolerance for risk. Over time, gains and losses in the market inevitably change the portion of your portfolio that is allocated to each asset class. If stocks perform strongly, they may make up an increasingly large percentage of your portfolio, which may expose you to more volatility than suits your circumstances. Conversely, if bonds post strong returns, they may make up a greater portion of your portfolio—and leave you with less growth potential than you’d originally planned.  
• Inflation. The rate of inflation has been low in recent years, averaging just 2.8% over the last 20 years.³ Many investors’ portfolios were constructed in this low-inflation environment. Should inflation increase in the years ahead, as some experts predict, your investments might not provide enough growth to outpace inflation. In fact, even with low rates, inflation nibbles away at your purchasing power over time: You would need $167 today to buy what $100 could purchase 20 years ago.⁴ Historically, stocks have offered the best hope of beating inflation: From 1926 through 2009, stock returns beat inflation by an average of 6.8% a year.⁵
• Interest rate risk. Changes in interest rates also may affect the value of your investments. For example, when interest rates rise, bond prices fall. The outlook for interest rates has changed considerably during the past several years, and may call for adjustments to your investment strategy.

Take the first step

The battle against investing inertia begins with just one simple step: Choose the type of financial plan or goal you want to achieve. “You get to decide how big of a problem there is to tackle,” says Gold. “Do you want to revise your entire financial plan or just determine if you’re contributing the appropriate amount of your salary to your 401(k) plan?”

There’s no one right answer here—you have to set the goal for yourself. But, as Gold points out, the key is to not try to do too much. It’s easy to start the process with grand ambitions, but then feel overwhelmed and give up. “Take it at a pace that works for you,” he says

For example, you may currently feel paralyzed after following the market turmoil over the past two years. Rather than trying to charge past your fears and make changes to your portfolio right away, Gold suggests first addressing your emotions. “If you’re worried that you don’t understand what happened in the last few years, your first job is to work on understanding it,” he says. “The cure for feeling anxious is to gain some facts.”

Develop a plan

After you get past your inertia, take advantage of your momentum and establish a financial plan. Begin by listing your short- and long-term financial goals, and estimate the cost for each.

Next, determine the appropriate mix of investments for each goal. To do so, you’ll need to know how long you have to save for each objective and your tolerance for risk. Many investors think of “risk” as shorthand for “short-term losses.” But, says Gold, it’s important to consider the various types of risk that could get in the way of achieving your goal—including inflation risk, interest-rate risk, and longevity risk (the chance that you will outlive your savings).

You may have asked yourself these questions before, but they’re worth revisiting,” Gold says. “It may be a little harder to answer them now, following a scary market downturn, but they’ll provide essential information for developing your plan.” 

You also can develop strategies to help prevent your emotions—and inertia—from again creeping into your investing decisions. For example, you may want to consider setting up an annual portfolio review; if your asset allocation among domestic and foreign stocks has strayed from their target allocations by more than 10 percentage points, you should either rebalance to restore your portfolio to its target allocations or speak to your advisor about a potential new asset allocation strategy.

Meanwhile, don’t beat yourself up if you struggle to make investment decisions. “When your emotions are engaged, it’s tough to make a decision,” says Gold. Instead, take small concrete steps to overcome inertia and face your investing fears. This approach will help you take better control of your financial future—rather than letting circumstances control you—and make progress toward your most important goals.

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