The Checkup: Issue 5
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Welcome back readers! I hope you are all enjoying your summer and staying active and healthy. Did you know that one of the predictors of your long-term success as an investor is primarily influenced by individual psychology and behavior? This month’s newsletter is an intro to money psychology.
There is much to discover on this topic, and we will only begin to scratch the surface. My goal with this issue is to give you a high-level overview of some of the building blocks of money psychology and build upon them in later issues. In this post, we will explore Cognitive Biases and the Psychology behind Spending and Saving and discuss actionable steps to help you avoid these money traps.
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Introduction:
?When it comes to achieving long-term investing goals, sticking to a plan and financial knowledge are undoubtedly important. However, an individual’s behavior, psychology, and habits play an equally important role in determining investment success. Understanding how these psychological factors affect decision-making can significantly impact an investor’s ability to stay disciplined, make rational decisions, and navigate the often-unpredictable waters of the financial markets.
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?Understanding Cognitive Biases:
Cognitive biases are unconscious mental shortcuts that influence our decision-making processes. These biases are a natural part of human psychology and have evolved over time, but in the context of investing, they can be detrimental to long-term success. Emotions like fear, greed, overconfidence, and FOMO can cloud an individual's judgment and lead to irrational decision-making.
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1.???Overconfidence Bias:
?One of the most common cognitive biases among investors is overconfidence. It occurs when investors believe they possess more information and skill than they actually do, leading them to take on excessive risks or trade too frequently.
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2.???Herd Mentality aka FOMO:
?The herd mentality stems from the human desire to fit in. Investors may feel the need to follow popular trends without doing proper due diligence.
?Example:
?The rapid rise of meme stocks and cryptocurrency during the pandemic. You can find many stories online of investors who unfortunately lost lots of money from blindly investing in a stock because of its popularity.
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3.???Loss Aversion:
?Loss aversion bias occurs when investors place more emphasis on avoiding losses than on making gains. This mindset can lead to irrational decisions, such as hastily selling positions during times of market volatility. Doing so will lock in your losses and lead to missing potential gains during the recovery. This mindset can also cause an investor to hold onto losing investments for too long or sell winning investments prematurely.
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4.???Confirmation Bias:
?Confirmation bias occurs when investors seek new information or distort new information to support their existing view. It is common for investors to become overly attached to some of their investments and only look for information that is favorable to the holding.
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The Psychology of Spending, Saving, and Investing
?The way individuals handle money is often a reflection of their emotions and psychological tendencies. Impulse buying, for example, can be a coping mechanism for stress, loneliness, or boredom. In the moment, the act of shopping can trigger a temporary positive emotional response, leading to a desire for more spending. However, this can create a harmful cycle of financial strain and emotional dependence on material possessions.
?Example:
Most episodes of the TV show Hoarders.
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On the contrary, some individuals may adopt a frugal lifestyle as a reaction to past experiences or anxieties about the future. Saving money can provide a sense of security and control over one's life. While responsible saving is beneficial, an excessive fear of spending can lead to emotional deprivation and hinder experiences that contribute to overall well-being.
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Breaking Free from Emotional Money Traps
?Now that we have identified some of the money traps that we can fall into. Let’s discuss some actionable steps to avoid them.
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1.???Self-awareness:
?Understanding the complex connection between money and emotions will help develop a healthier relationship with your personal finances. The ability to recognize your own emotional triggers and how they influence your financial decisions can help mitigate poor financial decisions. Take some time to ask yourself questions about the connection between money and your emotions, such as:
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2.???Have a Plan:
?Setting clear, measurable, and achievable financial goals can serve as a roadmap for decision-making. Establishing some boundaries on spending and saving can help avoid impulsive decisions driven by emotions. Ideally, your plan should align with your goals and values. There is a great show on Netflix by Finance expert Ramit Sethi called, How to Get Rich. In the show, he works with individuals and families from a variety of financial situations and helps them put together a plan to achieve their rich life. His core belief around finances is this, “you should spend extravagantly on the things that you love but cut costs mercilessly on the things you don’t” ~Ramit Sethi. I’m a big fan of this philosophy and believe it’s an excellent thought process to use while designing a financial plan. Creating a plan that aligns with your personal hobbies, lifestyle, passions, and future goals helps you to be more connected to your plan and can help you avoid making irrational financial decisions.
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3.???Seek support:
?If you find yourself struggling to break free from emotional money traps, talk to someone that you trust. Talking about financial matters with friends, family, or a financial advisor can alleviate emotional stress and provide valuable perspectives. Even the most disciplined investors may benefit from seeking professional advice. Financial advisors can provide an objective perspective, help manage emotions during turbulent times, and guide you toward suitable strategies based on your goals & objectives.
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4.???Patience & Discipline:
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Whether your goal is saving for retirement, paying off debt, or planning a big purchase, accomplishing financial goals takes time. Having a patient and disciplined approach to achieving your goals can help you avoid the natural tendency to look for shortcuts. When implemented with a plan, exercising patience and discipline while building sustainable habits can help you avoid costly mistakes and give you the confidence needed to accomplish your goals.
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Final Thoughts:
?While knowledge of financial markets and investment strategies are fundamental, your behavior, psychology, and habits play an important role in long-term investment success and achieving financial goals. By understanding the psychological factors that can impact financial decisions and cultivating positive habits, you can build the patience and discipline needed to stay on course, navigate market fluctuations, and ultimately achieve your long-term investment objectives. Remember, successful investing is not solely about crunching numbers, it’s about effectively managing yourself in the face of a constantly evolving financial landscape.
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?Helpful Resources:
Discover your money personality type:
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The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness by Morgan Housel
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Thinking, Fast and Slow by Daniel Kahneman
How to Get Rich | Netflix
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The Economy:
?During this month’s FOMC meeting, the Fed raised rates by another 25 basis points (a ? of percent). Fed Chairman Jerome Powell acknowledged that the June inflation report came in better than expected, but stated one month of good data isn’t significant enough to make the Fed deviate from its 2% inflation goal.
The general tone of the meeting felt cautiously optimistic. There were several good economic data points highlighted, and the Fed seems to be pleased with how the tightening has affected the economy so far. However, the Fed is aware of the lagging effects of raising rates. Jerome Powell stated, “The full effects of our tightening have yet to be felt.”
One aspect of the economy that is still a concern for the Fed is the labor market. While the jobs-to-workers gap has narrowed, labor demand still significantly exceeds the supply of available workers. Moving forward, the Fed will continue to look for signs of the economy expanding at a slower pace, a better balance of the supply and demand of the labor market, and inflation as they make the decision to raise rates in September or hold steady.?
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?Stocks
?Dow: 35,479.19 (+7.07%) YTD as of 07/31/23
S&P: 4,587.13 (+19.95%) YTD as of 07/31/23
NASDAQ: 14,335.96 (+38.02%) YTD as of 07/31/23
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July News Round Up:
·????????Elon Musk rebrands Twitter as ‘X’ (CNN)
·????????Tesla beats Q2 delivery estimates (RT)
·????????U.S. judge puts social media restrictions on Biden officials (CNBC)
·????????Meta releases new social media app to compete with Twitter (CNBC)
·????????Nasdaq rebalances it’s holdings (FORBES)
·????????Federal Reserve launches FedNow, instant-payments service (CNBC)
·????????Cathie Wood’s ARK fund hits 11 month high (RT)
·????????BlackRock names CEO of oil company to board (CNBC)
·????????UPS strike averted with new 5 year deal (RT)
·????????US Consumer sentiment rose to highest levels since 2021 (BBG)
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Did you enjoy this month’s issues? Share with a co-worker or friend!
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Disclosure: Investing involves risk. Depending on the different types of investments there may be varying degrees of risk. Socially responsible investing does not guarantee any amount of success. Clients and prospective clients should be prepared to bear investment loss including loss of original principal. The strategies and topics discussed in this issue do not assure profit or protect against loss.
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?????? Sharing Hope | Small Business Owner | Real Estate Investor | Educator | Family man |
1 年Super insightful Thomas. I think it great to make people more aware of they types of bias, as sometimes we aren't aware. And amazing info on how to break free off the traps. Thanks for sharing.