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Investor psychology: Your mood can cost you money

Investor psychology 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," says Nofsinger.

"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."

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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," says Nofsinger.

"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 enough time."

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 too quickly.

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 investment selections.

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 future.

"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 stocks.

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 problem.

If you're determined to be a do-it-yourself investor, a good place to start is by developing an investment philosophy, says Grzymala.

"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 choice."

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

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