Plenty of smart, responsible people create a solid financial plan, save and invest diligently … and then, their bright, shining plan suffers an eclipse. Most of the time, the culprit — the large object that gets between you and your plan — is human emotion.
Here are three suggestions on avoiding a financial eclipse. Unlike today’s natural eclipse, you can, and should, avoid the financial variety.
- Doubt yourself. That may be terrible advice if you want a job or a promotion. But in investing, humility is crucial. Most of us are over-confident investors. We think we know when the market is about to collapse or soar. We forget that we’re competing against trillions of dollars, much of it controlled by equally smart, thoughtful people who have far more time to analyze the market. Unless you have an audited, 10-year track record of all your investing activity, assume you are no better than average. What should the average investor do? Buy and hold low-cost, broadly diversified mutual funds.
- Embrace risk. We are wired to avoid risk. Studies conclude that a human facing a potential $1 loss needs a potential gain of $2.50 to feel the bet is “even”. Over the last century, the probability of creating wealth as a stock market investor has been high. But it means you have to ride out short-term bumps, some severe. An alternative to accepting at least some risk: falling prey to variable annuities, variable universal life and other over-priced insurance products. They do protect you against loss. But they force you to give up virtually all gain. That typically means your financial plan will only work with reduced expenses.
- Think slow. Nobel Prize winner Daniel Kahneman’s brilliant book, Thinking, Fast and Slow, demonstrates that one way to avoid bad decisions is to slow down. The human brain is wired to make quick decisions. That ensured our species would survive when cavemen had to fight a fast-charging wild beast. But in modern times, quick response probably ensures bad financial decisions. Before you do anything, slow down, think carefully, and then act.
Sooner or later the stock market will turn down — maybe for 6 months, maybe for 6 years. You will have to fight fear to keep true to your long-term financial plan. If your rational side can overcome your emotions, your financial plan will be a lot sunnier.