Common Investor Mistakes (and How to Avoid Them): Part IISubmitted by Occidental Asset Management, LLC on March 29th, 2013
““…inbred human propensities to swing from euphoria to fear and back again seem permanent… generations of experience do not appear to have tempered those propensities…”
–Alan Greenspan, Economist and former Chairman of The Federal Reserve
When it comes to investing, we are our own worst enemies. Rather than being dependent on quantitative financial realities, markets are driven by cognitive biases and human emotions. When we are excited and see others making money we want to dive in. Whether it is a rare tulip bulb in 1670 Netherlands, a 2000 internet stock, or a 2006 piece of prime real estate in Florida, when we feel like we are missing out, it makes us crazy. When we follow our instincts, we just can’t help buying high.
When we sense impending doom we feel implored to sell and pull all of our money out of the market. Financial planner across the country received sell-it-all-now calls from client as “fiscal cliff” madness hit the airways. Prudent planners suggested to clients that they not engage in reactionary investing and stay put. As it turned out, the anticipated crash didn’t materialize, and instead, we saw large stock market gains as the markets breathed a collective sigh. The prudent planner, however, did not take credit for timing the market correctly. He or she knows that the markets could just as easily have dropped. As boring as it sounds, the prudent planner’s recommendations are the same in market bubbles and market crashes: develop a strategy to meet your goals, invest and diversify accordingly, rebalance and adjust along the way, and stay the course. Studies have shown conclusively that market-timing efforts are losing strategies. If you are lucky, you may guess correctly once, twice, or even three times. However, with market timing, it is not a question of if you will lose, but when and how big.
In my last article, I explored the common investing mistakes of overconfidence, reference point fixation, and playing with the house’s money, and how they wreak havoc on investor portfolios. What follows are several other mental mistakes afflicting investors:
1. Seeking pride and avoiding regret. Researchers have identified what has come to be called the "disposition effect.” In an effort to feel good about their financial acumen, investors have a tendency to sell winning positions, even when they shouldn’t. In an effort to avoid feeling like an idiot, investors also have a natural inclination to avoid realizing a loss, even when they should. As such, when left to their own devices, investors will off-load their winning positions to lock in a gain and cling tightly to their losing positions, waiting for the stock or asset to come back to where it “should be.” The disposition effect adds to an undisciplined, market-timing approach with negative tax consequences (higher taxes in capital gains and missed opportunities to harvest tax loses).
2. Risk aversion. Suffering a financial loss can be downright disturbing. In our December 2012 study published in the Journal of Financial Therapy (“Financial Trauma: Why The Abandonment of Buy-and-Hold in Favor of Tactical Asset Management May be a Symptom of Posttraumatic Stress”) my Kansas State University colleague Dr. Sonya Britt and I measured symptoms of posttraumatic stress in financial planners in the wake of the 2008 financial crisis. Ninety-three percent of the financial planners we studied were experiencing medium to high levels of posttraumatic stress. Big financial losses can betraumatic. The experience of a traumatic event can result in changes in one’s belief structure in an effort to avoid further traumatic experiences. After a financial loss, some investors become much less willing to take risk. As a result, they may sell at the bottom of the market when they realize avoiding regret is impossible, and be on the sidelines when the market inevitably turns upward. The Great Depression led to an entire generation of risk avoiders, many of whom, with their cash stuffed under their mattresses, missed out on one of the biggest bull-run in history. Since hitting a bottom in March 2009, the market has more than doubled. Investors who existed the market in the wake of the 2008 crisis, missed out on the subsequent market recovery.
3.Trying to break-even. Sometime a financial loss creates a feeling of desperation in the other direction. Rather than avoiding risk, some investors double-down in an effort to make-up their losses. Research has shown that the desire to break even after a financial loss can be even more powerful than the impulse to avoid taking necessary risk. This effect has been illustrated at the horse race track, where gamblers take more long shot bets at the end of the race day, and at the Chicago Board of Trade, where traders who lose money in the morning increase the riskiness of their investing later in the day. Losing our heads in an attempt to break-even results in compounded losses and an eventual decision to excessive risk avoidance in this generation or the next (where children and grandchildren experiencing the effects of high financial risk-taking can develop an excessive risk avoidance).
Dr. Brad Klontz, Psy.D., CFP®, is a financial psychologist, an Associate Professor and Founder of the Financial Psychology Institute at Creighton University Heider College of Business, a Managing Principal of Occidental Asset Management (OCCAM). and co-author of five books on financial psychology, including Mind Over Money: Overcoming the Money Disorders That Threaten Our Financial Health.
You can follow Dr. Klontz on Twitter at @DrBradKlontz.