How Smart Is Your Money?

When markets reach highs and beat records, investing conversations start to talk about the "dumb money." The dumb money is not my term, by the way; it's how Wall Street refers to individual investors who repeatedly sell stocks at a low price, only to turn around later and buy them for high prices.

If the mistake is so frequent that it actually has a name, why do we keep doing it, and what can we do to stop?

When we make financial decisions we're faced with a choice: Do we act based on what we know or how we feel?

In an intellectual exercise, knowledge wins. But in the real world, we're hardwired to pursue the things that give us pleasure or provide security and run as fast as possible from the things that cause us pain. This genetic trait means that we're often driven by how we feel instead of what we know.

Here is an example. In December 2008, The Economist published one of its classic covers. I remember seeing this cover, and a year or so later being struck by how well the image captured how I had felt. In fact, when I saw it again I had an emotional response that surprised me as I thought back to those feelings. The picture made me feel like everyone else did during that time. I was depressed, sad, hopeless, and felt like I was a fool for not gathering what little gold I had left before it too fell into the dark, bottomless hole pictured on the cover.

But how I felt at the time was exactly the opposite of how I knew (in an intellectual sense, at least) I should act. Every investment decision should at least be informed by what we know, instead of driven solely by what we feel.

So if the market has been on a steady upward climb, and you're thinking about making a sudden change to your portfolio, here are a few things to consider:

1. Stop long enough to ask yourself if your decision is based on how you feel or what you know.
Is what you are about to do based on what is going on in the market or is it based on an investment plan you put in place when you were thinking clearly?

2. Don't just do something, stand there.
When dealing with investments there is often this feeling that we should be doing something. A lack of action implies we're missing an opportunity or making a mistake. Growing a garden takes lots of hard work, but at some point you have to let the plants grow. If you have a plan, let it work.

3. If you're still convinced that you need to act, take a mandatory timeout.
Write yourself a letter that explains what you intend to do and why. Pretend like you are trying to convince a wise friend that your proposed course of action makes sense. It might help to actually meet with someone you trust and talk it through. Putting it on paper can help you weigh knowledge versus emotion.

4. Please, ignore gut feelings when it comes to investing.
I can't tell you how many times I have heard people use that as an excuse to do something dumb.

I know, I know. Believing that we can remove all emotion from our decision making just isn't realistic. But we can still take plenty of steps to make knowledge the foundation of our financial choices.

A version of this post appeared previously at The New York Times.

Carl Richards is a financial planner and the director of investor education for the BAM ALLIANCE, a community of more than 130 independent wealth management firms throughout the United States. Visit Behavior Gap for more of Carl's sketches and writings.

The Motley Fool has a disclosure policy.

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