Take a Breath
Let’s say you finally bite the bullet and invest a nice little sum in a company you’d been hearing about for some time. All systems are go until one day the stock’s value drops a jaw-dropping 10 points. Do you run for the hills? The desire to get out (now!) is completely natural from a behavioral standpoint. But like other emotional impulses that hit fast — often without one iota of hard evidence to back up those butterflies in the belly — it’s probably wise to take a slow breath or two (or five) and ignore your gut instinct in this case.
In fact, our instincts and emotions can trip us up in many ways as investors, often without us realizing it. Here’s why — and what to do about it.
We’re Hardwired To Avoid Losing
The truth is, a person’s fear of losing $1,000.00 is roughly twice as extreme as the satisfaction we derive from earning that same $1,000.00, says Israeli behaviorist Shlomo Benartzi of UCLA’s Anderson School of Management. Psychologists call this “loss aversion,” and it is “a very powerful and common example in human decision making,” Benartzi writes in his book, “Save More Tomorrow.”
How does that play out in the market? Investors consistently tend to sell winning investments while holding on to losing investments — a behavior that’s also been dubbed the “disposition effect” by behavioral economists.
Loss aversion can prevent you from capitalizing on further gains in a stock that’s rising as well as benefitting from an investment that falls one day but later rebounds (as can happen when unexpected news or earnings that are slightly lower than predicted drive down the price temporarily).
We Tend to Follow the Pack
When a plumb investment suddenly seems to be going south, you might hear something on the news or from a friend that makes you want to take action before things get worse. Don’t. Keith Newcomb, CFP® and founder of Full Life Financial LLC in Nashville, Tenn., explains that when everyone’s listening to the same broadcasts and acting solely on the latest news, normally intelligent people may flock together like sheep, driven by — you guessed it — a common fear of loss. The thing is, this sort of “herding behavior” may not accurately reflect your investment target’s long-term prospects. Today’s news may be telling just a fraction of the full story — ignoring positive technicals and fundamentals that investors running with the pack are bound to miss, Newcomb says.
We Overreact to Media Reports
Newcomb recalls a panicked call he received from a client back in April 2013 when Microsoft dropped 5.25 percent after the stock was downgraded by Goldman Sachs and JP Morgan Chase. The client was watching the situation unfold on CNBC and wanted to sell. Newcomb advised otherwise. His technical analysis indicated that after “essentially going nowhere for 13 years Microsoft was in the early stages of a new long-term uptrend,” he said. Also, the 2013 downgrades were tied to a survey indicating that personal computer sales were dipping during the first quarter. Newcomb believed that Microsoft’s revenues were becoming “decoupled” from PC sales due to a shift to cloud technology and new income the company was making from monthly subscriptions versus sales of software in a box. Within a week, “Microsoft returned to its winning ways,” Newcomb says. On April 11, 2013, the price was 28.33 a share. Two months later it closed at 35.44, up 25 percent. On April 2, 2014, it traded at a yearly high of 41.66.
We Focus on Short-Term Over Long-Term Goals
How often have you heard someone (particularly 20-and 30-somethings) tell you that they cannot afford to put more than a pittance into their 401(k) plan at work—even with the incentive of a generous employer match, that they could never hope to earn regularly through virtually any investment approach? This is something behaviorists call “myopia.” This refers to short-sighted thinking. If there’s a generous plan match — where employees are entitled to 50 cents on each dollar they save on a pre-tax basis up to a certain percentage of salary — then an employee’s 401(k) represents one of the best investments she could ever make. Still, a March, 2013 survey by the American Benefits Institute and WorldatWork found over a third of participating companies believe that more than half of their plan participants are “leaving money on the table” by not contributing enough to take advantage of the full employer match.
We Trade Too Much
“The more actively investors trade, the less they earn,” conclude finance professors Brad Barber and Terrance Odeon in their report “Why Do Investors Trade Too Much?” The two, who hail from U.C. Davis and U.C. Berkeley respectively, followed 66,465 households with accounts at a large discount broker during 1991 to 1996, a strong period for the market. They found that those who traded most earned an annual return of 11.4 percent, 6.5 percent less than the main market index returned. In other words, they would have been much better off investing in a mutual fund or exchange-traded fund that mirrored the Dow Jones or Standard & Poors indexes than trying to beat the market by buying and selling stocks multiple times. In addition to earning less in returns, they also paid a lot more in transaction fees from trading so actively. The researchers found the average household turned over 75 percent of its portfolio annually, which can be costly in terms of transaction fees alone. Their conclusion: Look for “cheap, well-diversified, and tax efficient” funds that track very broad market segments and stick with them over time.
Janet Aschkenasy is a New York City-based financial writer. She has written a book on how behavioral impulses impact retirement investing.