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Psychology of Investing - Part 1: Academics vs. Emotion

| July 01, 2014
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You might find this hard to believe, but most financial advisors like to talk……and talk, and talk some more (I guess proof of this comes from the fact that I am writing this in the first place). Often times, our ramblings seem aimed at demonstrating how smart we are – investors tell us what they need and we in turn tell them how to get there. Too often, however, we focus all of our attention on the academic reasons behind our advice. After all, it is our education and experience that the clients are paying us for, right? Yes and no……

We advisors – the “academics” (with apologies to academia for the rather loose comparison) – are inherently biased toward portfolio construction aligned with stated goals and timeframes. There is nothing wrong with that. However, what is too often ignored is the investor’s true tolerance for risk, or more appropriately, short term volatility. This CANNOT be glossed over – doing so is a recipe for disaster. While the advisor understands that a vicious market pullback is most often temporary in nature, the client that has never experienced it feels like they are on the verge of financial Armageddon. And if volatility was not considered in great detail before implementation, the investor will often allow fear and emotion to cause the disastrous “buy high and sell low”. Any advice a financial advisor supplied, or any amount of homework an investor may have done on their own, is now rendered useless.

I suggest a three step process appropriate for investors and advisors alike – (1) determine very specific financial goals, objectives, and timelines , (2) consider at length the potential volatility associated with different investment strategies, and (3) construct a portfolio based around (1) and (2) above…..IN THAT ORDER. In other words, focus on risk tolerance (emotion) before security selection (academic), and not the other way around. Doing so ensures that you are spending at least as much time preparing for the “emotional” side of investing as you are the “academic” side.

Please remember that the opinions offered in this rant are my own, and do not necessarily reflect those of LPL Financial….or anyone else for that matter.

As always, most importantly, thank you to all of our clients for your continued trust and confidence in Round Hill Wealth Management.

Thanks for listening,

Doug

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