The Psychology of Investing: The Smart vs The Wise?

The Psychology of Investing: The Smart vs The Wise?

I sometimes think my clients feel that only the super-intelligent can really master the world of finance, and become truly wealthy. But it’s just not the case. Making it onto the Forbes 400 list is definitely not a guarantee that you also have the IQ of a genius. Even Bill Gates said that the traditional view of intelligence can be overrated, and other forms of intelligence get overlooked.

So having a high IQ and a degree from the top universities doesn’t mean you’re going to become successful or rich. You need a different kind of wisdom. Good investing and financial smarts isn’t about brain power; it’s about behavior. If you can look inwards and get the psychology of investing pinned down, then you’ll be well placed for success with your money.

The Psychology of Investing

Let’s look at two famous examples. First up, the collapse of Lehman Brothers in 2008 rocked the financial world. They started from humble beginnings in Alabama in 1850. But the financial crisis of 2007 brought them to their knees within months, simply because they didn’t react well to the immense risk the industry was facing.

Erin Callan, the Chief Financial Officer for Lehman Brothers at the time, graduated with an exceptional degree from Harvard, and a JD from New York University School of Law. Let’s call her pretty smart. But the company crumbled around her.

On the other hand, Warren Buffet had to be pressured by his father to go to college. But while he was still at school – at age 14, no less – he had saved enough money to invest into a farming business. It was a modest investment at the time, but he graduated from college as a wealthy man. He’s now one of the most successful investors of all time and his success just keeps on coming. So how did he do it?

“Investing is not a game in which the guy with the 160 IQ beats the guy with the 130 IQ. Rationality is essential … To invest successfully 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 the framework.”Warren Buffet

I love this quote from Buffet, and it sums up the whole idea of the psychology of investing. Investing is about level-headed decisions, and being able to avoid mistakes by not acting impulsively. It’s about controlling your emotions, and not reacting to the short-term volatilities of the market while keeping your long-term strategies in focus.

Where Does Your Money Mindset Come From?

Research into the psychology of investing shows that our financial decision-making is tangled in a web of our emotions. Our fears, our regret aversion and ego are among the factors that influence what we do with our money. Personal bias too. You have to do a serious amount of self-discovery to reveal your personal biases, but they can be as simple as the decade you were born in.

I remembered an article from years ago by The Economist, as it had a profound impact on me and subsequently on how I viewed my clients’ perception of their financial situation. The article said that people who grew up during the Great Depression would grow up to be more risk-averse than people who grew up in different decades. How interesting is that? People were emotionally scarred by the financial experience of their very earliest years.

They probably learned a lot from their parents during that time too. Your relationship with money is hugely influenced by your parents, and the values they passed on. So if you grew up during the Depression or in other periods of financial downturns, you’re likely to have developed more frugal habits with your spending and would be much more risk averse when it comes to investing. You know what it feels like to be poor, and value every dollar.

Understanding “Personal” Finance

With those building blocks being so unique to each person then, finance is just that – it’s personal. Everyone has a different idea about how things should be done. I bet they can tell you exactly why, and give you reasons to prove it. It’s their own lived experience, after all.

So what does that mean for your financial planning? Well, when I meet some clients with previous investing experience, it’s often clear that they have either been over-cautious or over-confidence. Neither approach will have worked well, so they’ve come to me for some guidance.

Reacting emotionally to market changes can mean that they’ve underperformed over time. Often people will make the classic mistake of buying more stocks when they’re doing well, and selling through fear when the market takes a tumble. Generally speaking, this is never going to work well and it’s better to hold your ground – but that’s for another post, another time.

Well – I’ll give you one example first. If you’ve followed the history of Netflix, their stock price has lost significant value not once, but TWICE. If you rode out the storms with them though, you’ll have done extremely well. But it takes some guts to stick it out.

No-one Can Predict What’s Going To Happen

And if you have a look at this article, and at just how badly it’s aged (i.e. the predictions made about Netflix’s recovery were TOTALLY out) then you’ll see why you shouldn’t believe everything you read! The future is a complete unknown. To compensate for that uncertainty, I’ve got three tips that might help.

#1: Give yourself some room for error

Leaving some room for error means you can endure the future unknowns. You need to give an asset room for growth.

#2: Spend less than you make

I’m not talking about a budget here. I’m talking about spending less on your investments than you make, so you always have a profit, and you always have that room for error. Buy a simple portfolio and then just be patient. A buy-and-hold strategy of 60% stocks and 40% bonds is ideal for someone who doesn’t want to suffer the volatility of the markets. It isn’t exciting, but it can work well. Don’t jeopardise your returns because you’re a bit of a thrill-seeker.

#3: Find a good advisor

A recent study by Vanguard showed that using a good advisor who uses the best wealth management practices can add about 3% in net returns over time. And as investors age and their portfolio becomes larger but their sources of income are more restricted, then the stakes get much higher. For many clients, entrusting their future to an advisor is not only a financial commitment but also an emotional one. It can certainly take a huge burden from their shoulders.

Move Forward with Confidence

If you’d like to learn more about the psychology of investing and how a greater understanding of some simple investment tips could serve you well, I would love to speak with you. Drop me a line, and I’ll arrange an appointment whenever and wherever it’s convenient for you. I look forward to meeting you.

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