Tuesday, March 4, 2014
Investment decision-making should be based on rational considerations. Here are three ways emotions may guide your investing and what you can do to avoid them:
- Keeping a losing stock. Holding a security with an unrealized loss may trigger the behavioral bias known as loss aversion. Hoping to avoid the pain of a realized loss, the emotional investor hangs on to the stock hoping it will rebound. The rational investor will calculate the expected relative value of selling against holding onto the losing stock. The rational investor will try to figure out why the stock declined in the first place and then determine whether holding onto the losing stock is likely to yield a better return than reinvesting the after-tax proceeds.
- Holding one stock. Many investors during the late-90s technology bubble had an entire portfolio dominated by the securities of their employer. Instead of tying your livelihood to one company’s future success, use a technique called reframing to change your mental starting point. Instead of a starting point of $10 million in stocks, start instead with an assumed pile of $7 million in cash. Reframing can move you to a rational investment decision, which would be to sell off some employer securities in order to diversify into other assets.
- Listening to experts. Skepticism is often warranted when given someone’s “expert judgment.” Ask yourself whether the “expert” really has the requisite knowledge to recommend the investment as well as any ulterior motives. Also, take a step back and consider how realistic the stated track record is. "Real-life experience suggests that markets are mostly efficient on average and over long time periods, but are subject to irrational investor behavior over shorter terms."
See Larry Light, Unholy Trio: Emotional Investing Traps That Kill Your Returns, Forbes, Jan. 16, 2014.