(Editor’s note: Mark Neil is a principal with Northwest Wealth Advisors, Inc., an independent registered investment advisory firm with offices in Portland. Email him at mneil@strategic-co.com). He reports that his firm specializes in using a values based approach in helping clients achieve their life and investment goals) Are You a Nervous Investor?
The current market environment has
caused many investors to ask themselves serious questions about their portfolios.
The last several years have been rough on investors’ emotions. First we
witnessed the “irrational exuberance" of the 1998-99 market, where virtually
every stock investment grew. Tech stocks seemed to be riding rocket
ships to the moon as prices and valuations reached unprecedented levels.
Investors jumped on the bandwagon and continued to feed the frenzy.
The last two years brought the rockets crashing back to earth, along with
many investors’ retirement, college savings and vacation plans.
What have we learned? As an investment advisor I found myself managing client emotions more than their portfolios. They often let their emotions play the dominant role in financial decisions. Psychologists tell us that all decisions we make are based on emotion, and then we search for facts to back up those decisions. Some of us need fewer facts, some need a lot more. For me it is important to gather insight into the thought process of a client in order to provide better advice. Contrasting investment approaches Classic investment theory holds that investors arrive at rational conclusions after carefully considering all available information. They assemble their alternatives, assess probable outcomes and then arrrive at the “optimal solution.” They focus on the long-term horizon and make periodic adjustments to their portfolios by careful rebalancing back to their original plan. At the same time they are making systematic deposits to their portfolios to take advantage of dollar cost averaging. Current conditions may concern them, but they stick to their plan. Does this describe you? Behavioral finance approaches the methods of investor strategy in a different way. It recognizes that investors are not totally rational beings, they don’t always gather all of the facts and they seldom approach decisions in a systematic, pragmatic manner. They may even misinterpret information and act in the wrong way with the right information. Does this sound more like you? Behavioral finance is a good source of insight into investor actions. Behaviorists believe that investor behavior is not random, nor totally irrational. They believe that non-rational behavior falls into predictable patterns and can be prevented. Ultimately, this gives investors the tools and techniques to counteract destructive decisions. Some common mistakes There are a number of investor characteristics that behaviorists identify as common. Perhaps you’ve experienced some of these yourself, such as the “disposition effect.” This refers to the tendency to hang on to losers and sell winners. Most investors are loss-averse and try to avoid the pain of losing. So, by only selling their winners they experience the euphoria of winning. By not dumping their losers, they avoid the pain of loss, and -- being optimistic like most of us -- they hope the loser will return to being a winner. To counter this behavior, the investor needs to understand that investing is a “probalistic” endeavor. If you invest in the stock market, you’ll experience both profits and losses. You need to recognize losers early, based upon sound selling rules, and get rid of them. Buying a stock is easy. Selling it at the right time is much harder. Another common behavior is the “regret and hindsight bias.” This happens to us all. Usually we beat ourselves up when we make a bad decision -- when doing nothing would have avoided the pain. Hindsight bias is the way people perceive the past. Investment decisions that turn out well are seen as inevitable, while bad decisions require someone to be at fault. In other words, you give yourself less credit when you make the right decision and lay more blame on yourself than you probably deserve when you make the wrong investment decision. A helpful tool in handling this behavior is to recognize that there are bad decisions and there are bad outcomes. If you have a long-term investment strategy based upon sound buying and selling decisions, you still must expect some bad outcomes. Since much of what happens in the market is outside your control, events
like these are rarely the result of bad decisions. (A bad decision
is if you bought a stock based on a hot tip from a friend or neighbor.)
The trick to battling hindsight is to recognize what has happened, take
the loss, then move on. If in the process you learn something about
yourself, or the Investing is not as easy as some make it out to be. Besides the traps and pitfalls of the economy, Federal Reserve decisions, corporate accounting scandals and world politics, investors also have to deal with their own emotions and behavioral hangups when making investment decisions. The disposition effect and hindsight bias can make it difficult to stay the course, especially so in the trying times we currently face. Recognizing these behaviors and using techniques to overcome them can take some of the emotion out of your investment decisions and allow a better night’s sleep. © 2002 Mark Neil |
technical
aspects of investing, you'll be better for the experience. When Edison
was asked how he managed to keep going after years of failure at trying
to make a light bulb, he said words to this effect to a reporter, "Those
weren't failures. One by one, I successfully discovered each of the
999 ways to make a light that didn't work. After that process of
elimination, the only approach left was the one that did."