The economy will always have its ups and downs. But letting those swings affect your emotions can lead to irrational money decisions. Here’s how pessimism can adversely affect your finances.
Why it’s easy to be pessimistic
Even the savviest investors can fall victim to their natural cognitive biases. One of the most pervasive when it comes to money is called loss aversion, which causes us to be more sensitive to bad outcomes than good outcomes. For example, psychologists have found that brain activity is stronger in response to gambling losses than to gains.
This bias can cause us to pay more attention to the bad things in the news, like high inflation or COVID-19 case counts, and less attention to positive things, like the strong job market or how well your 401(k) is doing lately.
Cerulli, a research firm covering the financial services industry, found many investors say they exhibit common cognitive biases. For example, 71% of investors Cerulli surveyed say they tend to be influenced by recent news and experiences when making investment decisions, which is known as recency bias.
How pessimism can affect your money
These biases can lead to bad money decisions. For example, Scott Smith, director of retail investor advice relationships for Cerulli, pulled money out of equity markets in March 2020, anticipating a pandemic-fueled crash. There was good reason to be pessimistic. But while markets dipped initially in March, the stock market continued on an upward tear. Pulling money out of the market was a losing bet, though every indicator seemed to say otherwise.
“I can’t imagine how bad things didn’t happen with so many people out of work and the economy shut down,” Smith says.
How to counteract pessimism
It’s best to take the long view on your investments, Smith says.
“Once you let short-term news affect your long-term portfolio it becomes gambling,” he says.
That’s because you have to guess right twice: You have to pull your money out before the market goes down, and get back in before it goes back up. That’s really hard to do, but another cognitive bias, overconfidence, leads us to think we can manage it.
Usually, when it comes to investing, taking ourselves and our biases out of the equation is the best move.
“If you buy the S&P500 and close your eyes and don’t look at it again, you’re probably going to be better than the vast majority of investors who are trying to actively time the market,” Smith says.
That’s not to say emotions can’t play a role in your finances. You’re not Spock. You have goals, like retiring early or buying a house; your financial picture should reflect that. And it should also reflect your risk tolerance. If having 90% of your money in the stock market leads to sleepless nights, it’s OK to put some money in safer investments, even if it’s not the most profitable move.
Where your emotions and biases can get you in trouble is when you make quick, short-term decisions with your money. That’s why Smith says talking to an informed third party can be very helpful. It’s easier than ever for people to take their investments into their own hands thanks to apps like Robinhood, but talking to someone like a professional financial advisor can help put your initial reaction to gloomy financial news into the context of your long-term goals.
“That’s not exciting,” Smith says. “That’s not sexy. But sometimes boring is better.”
Image: Alfred Gescheidt / Getty