It is sometimes said that “money can’t buy happiness.” While this is true in a literal sense, and there is some debate about the subject in a figurative sense, one thing we know with certainty is that there is a link between emotions and money. Emotions can have a significant impact on investment success, and investor satisfaction, so it is important to recognize how they factor in.
Mo Gawdat, the Chief Business Officer at Google X, recently penned a self-help book entitled Solve for Happy. The book encourages people to engineer their own path to joy using the Happiness Equation:
HAPPINESS ≥ Your Perception of the EVENTS of your life – Your EXPECTATIONS of how life should behave.
Although his book was written to provide insight to those seeking more fulfillment in their lives, this simple but profound equation is relevant to money and investing, as well. An investor’s happiness quotient is dependent upon setting realistic expectations about potential returns and viewing returns and market fluctuation in the proper context. For example, is a x% annualized rate of return good or bad? This question cannot be answered in a vacuum. Was the portfolio diversified or concentrated? What asset classes were included? What was the return of those various markets during that period? What was the risk that you assumed to achieve that return? Is this return pre-tax or after-tax? Is it net or gross of investment costs? Investors who consider their investment experience in this context will tend to have better results in the Happiness Equation.
Setting expectations is important in both periods of positive and negative returns. During times of strong markets, an appropriately diversified investor always experiences returns that are lower than the highest performing single asset class. The emotional response to positive performance that was not as high as expected might be to concentrate into the highest performing asset class, but this emotional reaction has the effect of substantially increasing risk in a future downturn. Conversely, during bear markets, an investor with unrealistic expectations about downside risk might be more inclined to sell after substantial losses, thereby locking in losses and reducing the probability of long-term success.
Although there are some economic indicators that suggest that the likelihood of a recession is increasing, it may not be imminent. Nevertheless, now is a good time to consider how a significant market downturn could affect your portfolio. When the inevitable downturn comes, keeping your emotions in check will improve your probability of success and improve your Happiness Equation.