"Financial decision-making is not necessarily about money."
It's 5 am, it's still dark, and the snow is fresh. It snowed about an inch last night. As much as I want to stay in bed and keep warm, our dog, Bingo, and I are out on our morning walk.
As we walk down the trail that's next to our house, I notice other dog prints in the snow and think to myself, "Wow, it's so early, but I'm not the first one walking this morning." Bingo likes smelling footprints in the snow. As she smells these dog prints, her head immediately pops up and looks around. "That's unusual," I think to myself as we continue our walk.
Our regular morning walk is an out and back route on the trail. About 100 yards before our turn around point, I stopped dead in my tracks as I hear the loudest coyote I've ever heard coming from right in front of me. When I saw those paw prints a half-mile back, it didn't occur to me that there were no human footsteps next to them.
One coyote isn't so bad, I think to myself. But then I hear another one yipping on my right side. Then another. Then another. Four or five coyotes are howling all around me. We immediately turn around and head home at a pretty quick pace.
Let me tell you a story about a guy I'll call "Paul." In 2008 while stock markets were falling and the media was predicting an apocalypse, Paul watched as his retirement account balances dropped. Paul didn't have all of his money in stocks; he had about half of it in stocks. That means if stocks fall 40%, Paul's balances drop about 20% (depending on what his bonds did at the time). 20% isn't as scary as 40%, but that didn't matter. Paul feared losing more money and sold everything and kept his money in cash.
Stocks have almost tripled since he sold them and he missed out on all of the growth.
Let me tell you a story about a guy I'll call "Ryan." Ryan is in his early 30s and has built up a pretty good net worth for himself, especially given his age. A good portion of his assets are in investments, split between retirement accounts and taxable accounts. In 2016, citizens in the United States elected a politician whom Ryan thought is very scary. He assumed that since the scary politician was now an elected official the stock markets were going to crash. Like Paul, he sold everything and kept his money in cash. He feared his net worth getting cut in half or more.
Stocks have been up since Ryan sold his investments and he has not purchased stocks since.
In all three cases, something scary happened. In only one case was acting on the fear the right thing to do.
It's natural for us to want to do something (turn around and go home, sell our stocks) when we encounter something scary (being surrounded by coyotes, a down-market, politicians being politicians). It makes sense to distance ourselves from harm's way and do something to change our circumstances. But while it makes sense when it comes to physical threats in our environment, too many of us try to apply the same techniques to financial threats. Counter-intuitively, doing nothing is almost always better for us when it comes to our money.
We tend to be uncomfortable when we aren't doing anything, especially in times of high stress or when something seems to be going wrong. If this doesn't describe you, chances are you know several people who can't sit still.
I've heard this called the do-something illusion. It describes the idea that our perception of something bad happening (or likely to happen) makes us want to do something about it.
The illusion is that many times, doing something is exactly the wrong thing to do. It's a difficult concept to understand because it feels like doing something is productive; it feels like not doing anything means you don't care.
You can thank your ancestors for this feeling.
Fear and Risk
We're hardwired to avoid risk. This hardwiring is called fear. Fear and risk are deeply rooted in us - for good reason. Back in time, the people who didn't feel fear and underreacted to risks didn't survive to become our ancestors.
Take a look at the grid below. The horizontal axis shows how real the risk is. If something scared us, but we had nothing to be afraid of, I call that "false risk." If we were justified in being scared, I call that "real risk." On the vertical axis is our reaction. We can overreact or underreact. You'll notice that if the risk turned out to be a false risk, it doesn't matter whether we overreacted or underreacted to the risk. However, if the risk was real, the difference between overreacting and underreacting was life or death. Hence we developed a bias toward overreacting.