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Getting Emotional

Jonathan Clements  |  August 15, 2020

WHEN A FAMILY opts to purchase a Mercedes rather than a Subaru, the rest of us might think they’re being extravagant. But you likely won’t find many people saying, “How stupid is that? They could’ve got around town for half the price.” We accept that a car isn’t a strictly utilitarian purchase.

But we aren’t nearly so forgiving when it comes to “suboptimal” investment and personal finance decisions. Today’s contention: We shouldn’t be too quick to deride the money choices made by others—and, at the same time, we should concede there’s an emotional element to many of our own financial decisions and we should stop pretending otherwise.

For instance, many folks prefer to invest in companies that meet various environmental, social and governance (ESG) criteria. I have no problem with that—until these folks try to justify their investment by arguing that ESG criteria lead to better returns. The evidence on that one is mixed. But it’s also immaterial: This isn’t why these investors favor ESG companies. Instead, their investment approach is driven by their values. They’d own the stocks of ESG companies whether they offered better returns or not, so why not say so and be done with it?

Similarly, if you’re in good health, it typically makes sense to delay Social Security—and that’s doubly true if you’re married and you were the family’s main breadwinner. Yet many folks claim at 62, the earliest possible age, and then desperately try to justify their decision with absurd scenarios that typically involve stashing the money in stocks and then earning handsome returns. The reality: When people claim Social Security early, it’s often because they hate the idea that they’ll delay benefits and then head to an early grave, having got little or no money back after decades of payroll contributions. So how about just admitting that—and dropping the spurious justifications?

Among our many emotion-tinged financial decisions, perhaps the most important is settling on our portfolio’s basic stock-bond split. On social media, I’ve seen commentators lambast others for being too aggressive or too conservative. Such criticism presumes there’s an objectively correct asset allocation for everybody. But how could that be when we need to consider that tricky, subjective notion known as risk tolerance? When each person’s individual feelings about losses and gains factor into the choice, none of us should claim our asset allocation was solely a rational decision—and nobody should be attacking others for somehow getting it wrong.

This spills over into the debate over whether to invest a lump sum right away or instead spoon the money into the stock market over time. Because stocks go up most of the time, the gradual approach is dismissed by some as irrational. I disagree. What counts isn’t just the odds of success, but also the consequences of failure: If we invest a big sum right before a bear market, the financial fallout could be dire. On top of that, those who deride the go-slow approach are telling others that they’re being irrational—and yet we’re talking here about risk and, in the end, risk isn’t solely about volatility or probabilities. Instead, what also matters is the subjective emotional impact. How can we deride others for making a “mistake” when we don’t know how risk feels to them?

There are countless other financial decisions where emotional preferences loom large:

  • Many investors prefer stocks that pay dividends, because they like the idea that they’re regularly getting cash back. Yet, when those dividends get paid, the stocks involved drop by a comparable amount, plus taxable shareholders now owe money to Uncle Sam.
  • Families will buy second homes, touting the place as a good investment. Yet what they’re really doing is spending a heap of money on something that’ll give them lots of pleasure—but where they’ll likely break even at best.
  • Folks favor individual bonds because they like knowing precisely how much they’ll receive in interest each year and how much they’ll get back upon maturity. Yet, in return for that precision, they take on the uncertainty that comes with banking on a few individual bond issues. Indeed, if investors want confidence about their returns, bond funds—with their broad diversification—would be a wiser choice.
  • Many folks actively buy and sell stocks, claiming they’re beating the market. Yet often they have no idea how they’re performing compared to an appropriate benchmark index—and instead they’re trading simply because they enjoy it.

I’m not suggesting that we should always give in to our emotional preferences. Rather, when we make financial decisions, we should ask ourselves how much is driven by rational analysis and how much by emotion. And if the rationality is questionable but the emotional appeal looms large, we should ask whether it’s prudent to go ahead—or whether there’s some compromise that’ll sate our emotional side, without badly hurting our finances.

That might mean favoring dividend-paying stocks, but not with all of our nest egg. Or setting up a “fun money” account with maybe 3% of our portfolio, where we allow ourselves to trade stocks. Or claiming Social Security earlier, but at age 65, rather than 62. The bottom line: We should strive to recognize our emotional inclinations and perhaps accommodate them—but only if they don’t imperil our financial future.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Risking My LifeTake the Low Road and Just Another Day.

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