Investor psychology: Your mood can cost you money
If your investment portfolio isn't performing
as well as you would like, maybe your personality is the problem.
Experts say our emotions and biases can play a big part in our investment
choices and, all too often, lead to lower returns.
John Nofsinger, finance professor at Washington State
University and author of Investment
Madness: How Psychology Affects Your Investing ... And What to Do
About It, says there were people who lost 50 percent to
60 percent of their investment wealth in 2000 because they refused
to diversify and instead put too much money in tech stocks.
Nofsinger says the cause was overconfidence, and
those investors paid a heavy price for it.
"People feel that because there's so much
information available that it leads to good decision-making,"
"The Internet gives us quick access to
information, but it doesn't necessarily lead to knowledge unless
you know how to use that information. If you don't know how to interpret
it, it just leads to an illusion of knowledge."
Believe it or not, when it comes to making the right
decisions, whether in investing or anything else in life, our brain
isn't always our best friend, says Nofsinger.
The brain is like some "feel good" kind
of guy expending a lot of energy to make us happy -- even if it
means doing some tricks with the way it processes information.
According to Nofsinger, the brain, psychologically,
wants to avoid having to regret a decision and it has mechanisms
to do that.
"When we realize we made a bad decision, we feel
bad about it and it's hard to have a good self-image of ourselves,"
"We feel regret when we made an investment and
we lost money. The brain wants to avoid that feeling, so it tells
us we didn't make a bad decision, we just haven't given the investment
End result -- we hang on to stocks that are losers
and lose more money.
Bad brain. And, it doesn't stop there.
Fooled by your mind
Have you ever owned a stock for just a few months and it's done
well so you sold it to lock in profits? Three months later the stock
is still climbing and you're kicking yourself for pulling the trigger
Blame your gray matter.
"The brain is doing something I call 'seeking
pride,'" says Nofsinger. "The brain wants to seek things
that make us feel like we're doing well. We focus on stocks that
have gone up in value. It reinforces that we made a good decision.
We sell it to lock in the profit, but that's not always the best
thing to do to maximize wealth."
Really bad brain.
Shlomo Benartzi, an assistant professor at UCLA's
Anderson Graduate School of Management, has done extensive research
on the link between investor behavior and asset allocation in retirement
plans -- an area where most people get little guidance in making
A common mistake is buying a stock or fund because
it did well in the past instead of studying what it will do in the
"People extrapolate too much -- they're
looking in the rearview mirror," says Benartzi. "They
think the past gives them some indication of the future."
And there is the tendency to get emotional, notes
Jack Watson of the Fort Lauderdale, Fla., Early Bird Investors Club.
"Mob psychology is the biggest stumbling
block we have. If stock selection were cold-blooded -- based strictly
on facts -- we wouldn't make a lot of mistakes. People fall in love
with their stock, which is disaster.
"What's the company doing that's worthwhile?
Will they continue to do it? What's the price of the stock? Are
you getting value? The mistakes are on hunches, when people don't
investigate the company."
Another mistake Benartzi says people often make with
retirement plans is ignoring the fact that they usually have a long-time
horizon and behaving as though the time horizon is much shorter.
An example is allocating too much money toward bonds.
"A dollar invested in bonds in 1926 yielded
$35 by 1995," according to Benartzi. "Had it been invested
in stocks it would have yielded more than $1,100. Why, then, do
long-term investors own bonds? We showed that loss-averse investors
are sensitive to the evaluation period."
To test his theory, Benartzi asked ULCA faculty and
staff members how they would allocate their retirement savings between
two funds, based on historical rates of return.
Some participants were shown historical year-by-year
returns while others were shown long-term returns. Benartzi says
those who saw the annual returns allocated 40 percent to stocks,
while those who saw the long-term returns allocated 90 percent to
Do you have a familiarity bias? You might if you have
a lot of money invested in your company's stock.
"More than 40 percent of the money in
401(k) plans is in company stock," Nofsinger says. "It's
a recipe for disaster. People buy it because it's the company they're
most familiar with.
"If the company fails you could lose your job
and a portion of your retirement. You think a big company can't
fail? Look at Pacific Gas and Electric. Bad things happen even to
big, conservative companies."
What's love got to do with stocks?
Then there are the folks who fall in love with a stock.
"People have a hang up. They say, 'I bought Cisco
at $40, now it's down to $18.25 but I'll hang on -- it's a good
company,'" says Tom Grzymala of Alexandria Financial Associates
in Alexandria, Va.
"The problem is it might take another year before
it gets up to $40 a share. You might want to eat that loss and put
the money where it can do some good. Or do what I call the ying-yang
solution -- sell half."
How can you stop letting your emotions rule your investment
decisions? Depends on whom you ask.
UCLA's Benartzi says the best way is by hiring an
adviser to make the selections.
"The typical person doesn't do well picking a
portfolio. He doesn't do well prescribing medication for himself
or representing himself in court. People should get experts to do
this for them."
Nofsinger disputes that. He says many money managers
suffer from the same emotions and psychological biases that we non-professionals
have. So, having a pro make the decisions doesn't always avoid the
If you're determined to be a do-it-yourself investor,
a good place to start is by developing an investment philosophy,
"Determine your goals. Are they realistic? What's
your risk tolerance, your time horizon? Put it in writing and stick
with it. Design an investment portfolio around those aspects."
Grzymala worked up an example showing why it's important
to get out of the market-timing mentality.
"There were 4,590 trading days between
Jan. 2, 1980 and Dec. 31, 1997. During that time the S&P 500
had an average annual return of 17.1 percent. If you were out of
the market for the top 50 days of those 4,590 days, you had an average
annual return of 7.5 percent. Just 1.1 percent of all the days accounted
for 56 percent of the return."
Nofsinger favors some hard-and-fast decisions to take
emotions -- and that "feel good" guy in our brains --
out of the investment process.
"Make decisions about what you're going to do
in advance of being in that situation," says Nofsinger. "If
I buy this stock and it goes down 20-percent while the market hasn't
gone down, then I'm going to sell it.
"If you wait until it has dropped 20 percent
to make the decision, you're in the middle of emotion regret. Regret
says, 'Don't sell.' You don't want to face the fact you made a bad
Nofsinger likes having quantitative criteria for
investing. It doesn't matter to him what parameters you choose.
Figure out what's best for your investment philosophy. It can be
earnings, price-earnings ratio, market cap, maybe the size of the
dividend -- or the fact that it has a dividend. You decide.
Willpower is another important factor. Quit checking
your stocks and funds every hour, day or week. See if you can go
for a month without peeking. OK, maybe you'd have to be on a remote
island with no computer or phone access for that to happen. But
you get the idea.
The market downturn has forced a lot of people to
learn a painful lesson about investing. This is a good time to take
an objective look at your portfolio, determine if you've developed
some investing habits that are harming the bottom line and, perhaps,
try a different approach. It just might make a difference.
-- Updated: May 11, 2004