Do you remember Chicken Little and her band of barnyard friends? One day Chicken Little was scratching in her garden and a pebble fell from the roof onto her head. She thought the sky was falling and rushed to tell the king. Along the way she ran into Henny Penny and Ducky Daddles who joined her on her quest. Soon they encountered Goosie Poosie and Piggy Wiggy who frightened by the possibility of the sky falling decided to run with them. Soon Turkey Lurkey joined the group as they hastened onward.
All was going well until Foxy Loxy saw them coming through the woods. Foxy told them they were going the wrong way and offered to lead them on a shortcut. One by one Foxy Loxy lured each of the travelers into his home where he planned to put them into his crock pot. But before he could slam the lid each of them flew out the window and ran for home. When Chicken Little saw each of her friends fly out the window she became worried and began to scratch her head. As she scratched her head something fell from her feathers. It was a pebble that had fallen from her roof. Chicken Little immediately realized that the sky was NOT falling. It was just a pebble that fell into her feathers from the roof! And so, it is with investors.
During periods of stress and uncertainty we can display Chicken Little behavior. We convince ourselves that, when given all of the facts, we will think logically and act rationally. If you are guilty of responding emotionally to financial matters the good news is that it’s not your fault.
Blame it on your brain. Your brain is at work all the time. There are three sections of your brain. First is the hominid brain (responsible for language, for mathematics, for higher thought and reasoning). Second is the mammalian brain (responsible for feelings and the fight or flight response). And finally, the Reptilian or lizard brain (responsible for survival functions such as breathing and heartbeat). In times of stress the reasoning (hominid) part of your brain shuts down and the survival (lizard) part of your brain kicks in.
In addition to the way our brains are wired, there are some common biases at work that might inhibit your success when investing:
- Loss aversion occurs when you react more strongly to a loss than a gain.
- Anchoring occurs when your points of reference have no logical relevance. Chicken Little was convinced the sky was falling based on incomplete analysis of the information available. We tend to reach more strongly to losses than gains.
- Herding occurs when you follow the crowd. Henny Penny, Goosie Poosie, Ducky Daddles, and Turkey Lurky each demonstrated classic herding behavior. During uncertain times investors tend to react emotionally and follow the herd even though it may be detrimental to their financial wellbeing.
- Mental accounting occurs when you focus on just one of your assets rather than your overall portfolio. This behavior is best illustrated by investors who purchase an investment for $10 and it goes up to $100 and yet they complain that they have lost money when it drops back to $75. They have mentally locked into the highest value ($100) and are hesitant to sell at $75 although they have a gain.
Now is a great time to prepare financially and mentally. If you feel that your lizard brain is starting to engage make an appointment to see your financial advisor who will help you review your financial plan. You may need to refine and make adjustments to ensure that your portfolio is consistent with your tolerance for risk. Don’t hesitate to ask for clarity if you don’t understand the rationale for your investment strategy, plan and choices. Once these steps are taken you should have a plan of action in case the sky is indeed falling.