We like to think that since the advent of modern portfolio management practices, investing in stocks and bonds has become a cerebral, analytical process with no room for emotion. The truth is that most investors, even institutional investors, are buffeted by emotional turbulence from time to time, and that truth is reflected in the volatility of the financial markets.
But if a little emotionalism when it comes to investments is unavoidable, too much emotion can be hazardous to your wealth. Here are four symptoms of problem emotions, financial behavior that is inconsistent with sound investment practice.
Fear of loss. Investors are generally motivated by fear or by greed. Behavioral scientists have learned that, for many people, the pain of loss is larger than the sense of satisfaction from a gain of the same size. Similarly, some investors will accept larger risks in order to avoid a loss than they will in seeking a gain.
Taken to an extreme, fear of loss leads to investment paralysis. An excessively risk-averse investor may park funds in ultra-safe, low-yielding bank deposits or short-term Treasury securities until a decision is made, accepting long periods of low returns. Or winning investments may be sold off too quickly in an attempt to lock in gains, while losing investments manage to stay in the portfolio indefinitely.
Following the herd. It’s difficult to be a contrarian, to find value that everyone else has overlooked. Many people find it easier to go with the crowd, to own the current hot stock or hot mutual fund. At least that way, if the investment does poorly, one has plenty of fellow sufferers with whom to commiserate.
But when “crowd” is defined as one’s family and friends, the crowd’s investment goals may be very different from one’s own.
Hair-trigger reflexes. Markets move on news. In many cases, the first market response is an overreaction, either to the up side or to the down. Sometimes “news” is only new to the general public, and it’s already been reflected in the share price through trading by those with greater knowledge. The true importance of any news event can only be discerned over the longer-term.
Generally, it’s better to watch the market react to news than to be a part of the reaction. Remember that market dips may present the best buying opportunities but they’re also the toughest times, emotionally, for making a commitment to an investment.
Betting only on winners. Some 85% of the new money going into domestic equity mutual funds goes to funds with MorningStar ratings of four or five stars, according to one estimate. This may be one reason that the government requires this disclosure for investment products: Past performance is no guarantee of future results. The disclosure is required because it is true. High returns are usually accompanied by high risks; ultimately, those risks may undermine performance.
Abnormal returns, whether they are high or low, tend to return to the average in the long run. Investing on the basis of the very highest recent returns runs a significant risk of getting in at the top of the price cycle, with a strong chance for disappointment.
The Alternative Approach
To avoid impulsive decisions that may be tainted with emotion, one needs an investment plan. The best way to moderate the impact of stock and bond volatility in difficult markets is to own some of each. Assets do not move up down in lockstep. When stocks rise, bonds may fall. Or at other times, bonds also may rise when stocks do. The movements of each asset class can be mathematically correlated to the movements of the other classes. Portfolio optimization involves the application of these relationships to the investor’s holdings.
Expected returns need to be linked to the investor’s time horizon. Longer time horizons give the investor more time to recover from bad years, more chances to be in the market for good years.
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