With today’s economic uncertainty and market volatility, it’s important to understand the emotions that drive your investing decisions. Whether it’s greed, fear, optimism or something else, knowing what motivates you can help you avoid making mistakes.
Or, as Warren Buffett puts it, “Only when you combine sound intellect with emotional discipline do you get rational behavior.”
It takes all types to make the market run, but some approaches are more likely to lead to long-term success than others. Ask yourself which of these mindsets is most like yours:
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The Gambler
The gambler is usually looking to get rich quick or with little effort. For example, the odds of winning the grand prize in Powerball are 1 in 292,201,338; there’s no mathematical justification for buying a ticket. And yet, somebody’s going to win — and it could be you. So you play. That’s gambling.
In the world of options trading, most people are gamblers. Hoping that one big win will change their standard of living, they tend to put too much of their net worth behind their trades. They don’t pay attention to probability, and they don’t work out the odds.
If you gamble in the stock market, you might get lucky once in a while, but in the end, there’s a strong risk of losing.
The Speculator
Speculating involves taking a calculated risk with an uncertain outcome. It can be fine now and then, in the same way that going to a casino might be fun once in a while. But if it starts to consume you and you’re spending money that you can’t afford to lose, then it becomes a problem. You should thoroughly understand what you’re getting into and be prepared to lose all the money invested.
For most people, most of the time, that means speculating is inappropriate. Mark Twain says it this way: “There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.”
The Investor
Investing is, of course, very different from gambling or speculating. It involves a process: learning fundamentals, doing some research and having confidence in a company’s financial details.
A careful investor makes decisions based on sound information, not hope or emotion.
Here’s another Buffett quote: In 2006, he told shareholders, “You have to be able to play out your hand under all circumstances. But if you can play out your hand, and you’ve got the right facts, and you reason by yourself, and you let the market serve you and not instruct you, you can't miss.”
That means a smart investor doesn’t just look at a price and say, “OK, that must be what the company is worth.” He estimates the actual value of the company based on his research, or the research of a trusted financial professional.
Investing does involve risk, including the potential loss of principal, since no strategy can guarantee a profit, and few protect against loss in periods of declining values. The key is to not get emotionally involved. An investor asks, “Can I make a good decision today to buy this asset based on sound information?” If the answer is yes, he moves forward.
The Risk Manager
As a person approaches or enters retirement, his thinking has to shift. Accumulating assets is no longer the goal; converting assets to income is what’s important.
Risk tolerance should be a factor for investors of all ages, but for those in or near retirement, it must be a primary focus. With little or no time to recover, a large loss can destroy your nest egg.
The risk manager thinks about what can be controlled in retirement ‐ and that’s certainly not the markets. It’s a matter of what portion of retirement assets should be in market-based assets (stocks, bonds, mutual funds, etc.) and how much should be in alternative assets (indexed annuities, real estate, commodities, etc.). Volatility is the enemy; diversification is the risk manager’s friend.
Did you spot yourself in any of the above investment approaches? Maybe you’re a mix of two or three, or even all four.
The trick is to be self-aware whenever you’re making a money move. Ask yourself each time, “Am I being a gambler, a speculator, an investor or a risk manager?” You just might save yourself from making a retirement-wrecking mistake.
Kim Franke-Folstad contributed to this article.
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