Using Precommitment Strategies to Avoid Emotional Investing
Studies show that emotions can take over when financial stresses hit. But there are actions you can take today to help keep yourself on course with your investment goals in tough economic and market conditions.
Are Emotions Your Enemy?
According to behavioral investing experts, everyone has certain biases that can affect actions when stressful financial situations occur. For instance, faced with the pressure of the day’s news or market performance, it’s tempting to react and change strategy.
In strong markets, it’s common to hear stories about people making money from a trending investment. The fear of missing out on high returns can lead to making risky purchases.
On the other hand, market declines can induce fear of losing everything and prompt selling at low prices to “cut” losses—but it actually may lock in losses on investments that had the potential to recover.
How to Keep Your Cool With Precommitment Strategies
How do you keep emotions from interfering with your financial future? First, it’s important to recognize them and develop a framework for making better decisions. Then you can commit to actions today that can help prevent your future self from acting in ways that sabotage your goals.
"A precommitment strategy is often the best insulation against the effects of psychological biases. It essentially makes inertia an investor’s best friend."
Cass Sunstein, behavioral expert, author and Harvard professor
Do you pay bills online automatically each month? What about making automatic contributions from your paycheck to a savings account or 401(k) plan? These are precommitment strategies—good money decisions that you don’t have to remake each month.
You can use precommitment strategies with your investments too. Consider automatically rebalancing by setting an annual appointment with yourself or a financial advisor to review. If one part of your portfolio has done well while another has lagged, the discipline of rebalancing may reduce the risk that you’re buying high and selling low based on emotions.
Keep Emotions in Check With a Financial Planning “Architect”
Sunstein suggests a financial advisor can serve as a "plan architect" who understands the structure of your investment plan. "It’s not that your plan is set in stone," said Sunstein. Circumstances change. And it can be beneficial to have someone by your side to discuss if the plan still fits your goals and risk tolerance and talk through different situations.
The investor-advisor relationship also can be helpful when developing precommitment strategies that make it less likely you’re pulled off course when the going gets rough. For instance, you can agree to a phone call if the market moves up or down 10% or you want to move your money to a hot new investment trend.
Whether you go it alone or seek assistance, put your plan in writing and sign it. A letter you write to yourself can help strengthen your personal commitment to your long-term goals.
Commit to Yourself
No matter how much willpower you think you have, precommitment strategies can help you avoid temptation in the first place and let you make decisions in less stressful times.
Tomorrow’s success may depend on the careful steps you take today.
Behavioral content Cass Sunstein ©2023 All Rights Reserved
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Rebalancing allows you to keep your asset allocation in line with your goals. It does not guarantee investment returns and does not eliminate risk.