Hey everyone! Hope everyone’s having a great summer. It’s been a busy couple of weeks in the Panther household. Today, I’ve got a guest post for you from Anum Yoon who blogs over at Current on Currency. In her post, she talks a bit about the psychology that goes into investing. While I don’t recommend investing in individual stocks, her overall message works well for us index investors as well. Enjoy!
Many people believe they invest rationally. After all, most stock market investors want to realize a profit. That’s the entire point of stock market investing.
But research into human psychology indicates that investors are profoundly influenced by thoughts that are not necessarily rational. Over time, experts agree on the most rational strategy. Choose stocks wisely. Buy and hold for the long term. Reinvest dividends. Choose a fund that tracks major stock market averages like the S&P 500 rather than buying one or two stocks, to lessen your risk and maximize gains.
Buying and holding with a long-term view ensures that you do not sell at a low point by overreacting to a stock market slide that, in hindsight, turns out to be a minor dip in a basically upward market. In the U.S. stock market, pullbacks have been followed by gains steadily since the 1950s. Buying and holding ensures that you realize those gains. It also ensures that any reinvested dividends will contribute to your eventual profit.
Many investors, however, work against these principles due to the power of their thoughts on investment strategy. Read on to find out how.
Psychologists have determined what they term a “disposition effect” that has a marked pull on investor trading. The first part of the disposition effect is a tendency to sell a steadily advancing stock rather than holding onto it.
Now, investors should be overjoyed to see a steadily advancing stock, since it means they have a successful investment. And if they are aware of the merits of a buy-and-hold strategy, they should do anything but sell a winning stock.
Yet many investors do. Observers believe this happens because the people affected get a kick from realizing the profit. They get a happy, excited feeling when they see the share price rise. While at least some investors can get this kick simply from monitoring the stock and watching the price climb, others want to be able to feel happy about the money by having it.
Selling winners not only deprives investors of potential long-term gains and reinvested dividends, but it also costs them more in trading fees and taxes. So it’s an overall hit to an investor’s financial life.
But there’s another part of the disposition effect too. And that’s a tendency to hold onto declining stocks no matter what.
Research has shown that stocks that sink in price are held tenaciously by some investors. We’re not talking about underperformers — stocks that simply do less well than others. We’re also not talking about bear markets, when a large percentage of stocks decline. We’re talking about stocks that fall below the purchase price so investors have lost money.
While the logical move might be to trim losses and get rid of underperforming stocks, people affected by this part of the disposition effect will hold on in the hopes that they will eventually make back their money.
The reason is simple. Losing money is not pleasant. It causes pain. Investors affected by the disposition effect simply want to be in less pain. They feel like they are in less pain if they continue to hold the stock even if, rationally, they are still losing money. Worse, they are tying up money that could be invested more profitably elsewhere.
The Home Bias
A final way in which thoughts affect your investments is the home bias. This is a tendency to buy stocks of companies located geographically close to you.
But is this a bad idea from a logical standpoint? After all, shouldn’t we buy local? Doesn’t it show loyalty to a state, region or specific company?
These can be good things, and of course, a company close to you might be an excellent investment. The concern is that buying only stocks of companies located close to you may result in a portfolio that lacks diversification. Diversification is one of the principles of portfolio selection. A good portfolio should be in different sectors. After all, a group of stocks concentrated only in the technology sector is going to decline when technology goes downhill. Diversification protects against that.
In addition, the home bias may promote buying stock only in a company you work for. But that comes with a risk. If it goes out of business or cuts back, you may lose both your salary and the investment.
How to Protect Yourself
Now that you know about the disposition effect and home bias, how do you protect yourself?
The first way is to make sure you research stocks thoroughly. Identify high-quality stocks. Once you identify some, stick to them. Do not be swayed by aggressive promotion of stocks, such as sales calls. The sales person would be eager to answer questions and provide proper explanations to any questions you may have – if they don’t then it’s likely not a legitimate deal. Do not sell them after they make a profit. Use a buy-and-hold for the long-term strategy. If you invest in a local company, be sure to diversify accordingly.
The second tip is simply not to follow your stocks frequently. Seeing that they have risen or fallen in a given day or week may trigger the disposition effect. Break out of that trap by not triggering. Don’t check your stocks’ progress online every hour or every day. Don’t tune into financial news programs that have a ticker running.
You do need to know your portfolio’s performance, but you need to review it at longer-term intervals. Set a specific time, like once a month or once a quarter. Make prudent judgments. Don’t get excited and sell a winner! Don’t hold if a stock has lost a lot over a quarter.
Although many investors would like to say they make logical decisions, their thoughts may be less rational and lead to investment mistakes. The disposition effect and home bias can negatively affect your returns. To counteract these, research your stocks thoroughly and review your portfolio at long-term intervals.
Anum Yoon is a millennial money blogger who loves sharing insights on investing, retirement, and just plain old budgeting. Check out her blog, Current on Currency to read her posts.