Psychology and Fear in Personal Finance

Be fearful when others are greedy.  Be greedy when others are fearful.

-Warren Buffet

Warren Buffet is one of the most successful investors of recent times and provided this great quote in 2008 during the height of the subprime mortgage crisis.  During the 2007-2009 bear market, the S&P 500 lost over 50% of its value and many people close to retirement had to delay their exit from the 9 to 5.  In hindsight, as we sit in the middle of a bull market in 2016, Buffet’s quote is great advice, but how are you supposed to separate yourself from emotion when your nest egg loses over 50% of its value?

S&P 500 2007 - 2009 Bear Market
S&P 500 2007 – 2009 Bear Market (courtesy of Yahoo Finance)

There is no easy answer here, as personal finance is indeed personal, but you can certainly make good, informed decisions in the middle of emotionally charged circumstances.  Buffet was right about the subprime mortgage crisis and the need to buy while prices were low (i.e., while the market had lost lots of its value).  He likely looked at the history of the market and understood that it would bounce back.  As of September 16, 2016, the S&P 500 sat at 2,139.16 versus its lowest value during the subprime mortgage crisis of 676.53 on March 9, 2009.  As you can see, the market has more than returned.

S&P 500 - 2007-September 16, 2016
S&P 500 – 2007-September 16, 2016 (courtesy of Yahoo Finance)

How do you disarm fear and anxiety in personal finance?  Educate yourself.

Peace I leave with you; my peace I give to you. Not as the world gives do I give it to you. Do not let your hearts be troubled or afraid.

John 14:27

How should you manage fear and anxiety when making financial decisions?  Start with education, then don’t stop educating yourself.  Read personal finance books (I highly recommend The Millionaire Next Door), visit personal finance blogs (Afford Anything is my current favorite), and listen to personal finance podcasts (Marketplace is great for keeping up with current financial events; Afford Anything has a great podcast, too).  I’ve found that I pull pieces of information from each of these sources and, as a result, have molded a personal philosophy.

The key lesson here is that education will help you see that American equity markets have more than recovered from the multitude of previous crashes and bear markets.  Buffet understood this and saw that equities were simply on sale.

How else do you disarm fear and anxiety?  Understand risk and reward.

I recently listened to a personal finance podcast where I heard an interesting anecdote involving fear.  A caller indicated they hadn’t invested in the stock market for retirement due to their fear of losing money.  While the caller certainly is correct that avoiding the stock market and investing in something safer, like CDs or cash, will help you avoid risk and the large losses that can accompany risk, he is also missing the other half of the equation:  In finance risk is necessary for growth.

While the caller will seemingly preserve capital by avoiding the volatility of the stock market, their capital will erode over time due to the effects of inflation.  The eroding power of inflation will decrease buying power if not offset by gains.  One option for generating more gains than cash but experiencing less volatility than the stock market is the bond market.  The bond market, though, experiences a good amount of volatility, too.

While someone can certainly go to sleep peacefully knowing they will avoid the volatility of the stock market and keep their money safe (at least until inflation eats away at it), it would be rash to do so without being aware of the rewards that accompany carrying risk.  Over the past 30 years (specifically from January 1, 1985 through December 31, 2015), the compound annual growth rate of the S&P 500 was 8.2% with dividends reinvested and adjusted for inflation.

S&P 500 - CAGR for past 30 Years
S&P 500 – CAGR for past 30 Years (courtesy of MoneyChimp.com)

As you can see, $1 invested in an S&P 500 index fund on January 1, 1985 would have returned over 1,100% in 30 years.  While I can see how avoiding significant losses would allow someone to sleep peacefully, avoiding a significant amount of the S&P’s gains during this time period would cause me to lose sleep at night.  My advice to the caller:  Educate yourself about risk and reward, then understand how accepting additional risk could result in your nest egg multiplying in size.

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