Has Psychology Stolen Your Investing Objectivity?
It has been said that the way to earn the most from your investments is to keep careful track of them. But be very cautious before accepting this advice at face value; it may very well create more problems than you realize.
The more you pay attention to your own investments, the more you become psychologically vested in their performance. There is a proven tendency to keep an investment after a loss to avoid the pain associated with that loss, or to sell an investment after a gain to experience the feeling of a ‘winning choice.’ This is known as the disposition effect. Either action would be an example of using the wrong criteria for an investment decision, and most often, it leads to lower overall performance.
Perhaps you’re saying, “Not a chance! I don’t sell my investments because they’ve done well, I keep them because they’ve done well!” In that case, you have just brought up another psychological pitfall—forming expectations of the future based on events of the recent past. This is one example of a concept known as herding, and it’s potentially hazardous.
In the market, there is actually a reverse correlation between the recent past and the near future. In other words, if a segment of the market has done really well in the last three months, it is more likely to under-perform in the following three months, rather than continue its upward trend. This is known as reversion to the mean.
Now you’re saying, “Wait, so holding an investment because of poor performance is irrational, but so is holding an investment because of excellent performance?” The only answer is, “It depends.” Making investment decisions based on short-term past performance is generally plagued with irrational tendencies. However, making such decisions based upon long-term performance, relative to the investment objective being used, is far more appropriate, especially when in conjunction with other criteria, such as your time horizon, risk tolerance, and overall objective.
So what can you do to prevent irrationality?
Seek the help of a professional!
©2005 Matthew S. Clement, All rights reserved.
Matthew S. Clement is a financial planner and investment advisor representative with Financial Network Investment Corporation, member SIPC. He provides holistic wealth management and retirement planning to individuals and businesses. He can be reached in New York at (845) 942-8578, or by email: ClementM@FinancialNetwork.com.
Matthew Clement
