The best investors don’t let emotions rule their decisions. Sheryl Sutherland looks at how pride and regret can affect your investments.
There’s an old saying: pride goes before a fall. None of us likes to fail – it really damages our pride.
But we can’t help feeling like that. Human nature leads us to avoid regret and seek actions we can be proud of.
‘Regret’ is the pain we feel when realise a decision we made turned out to be a bad one. ‘Pride’ is the satisfaction we feel when a decision we made turns out to have a positive outcome.
These two emotions are the origin of many of the problems investors face.
We all hate to sell winners and hold losers. This is known as the ‘disposition effect’.
Investors believe that their current losers will, in the future, outperform the winners. Think of it like a ‘she’ll be right’ attitude. So, they hang on to losers.
There’s also a connection between the length of time you hold an investment in your portfolio and the return you get.
Studies have shown that investments that increase in value quickly are more likely to be sold quickly, as opposed to the ones which drop or remain level.
A study showed that assets owned for a short period of time tend to be winners, and those held for a longer period are more likely to be losers.
In fact, the average investor is more likely to sell a winner than a loser, because they feel the pain of loss more strongly than the pleasure of a gain.
How loss-aversion works
You might think that the tendency to weigh lows more heavily than gains is not entirely a bad thing. After all, an aversion to lows can be helpful by leading to conservative behaviour.
However, sensitivity to loss can skew your judgement in investing. Consider market crashes, where an aversion to loss makes most investors overreact and panic.
They sell, which drives down prices, compounding market losses and causing more pain – more loss of pride.
It doesn’t help when, later, you watch the prices bounce back while you’re still licking your wounds, regretting your actions.
An independent adviser can be helpful in these situations. You can lower your level of regret by blaming him or her.
Good news, bad news
Media reports affect how investors trade. How does this work?
Research found that investors react differently to news about companies in which they have money invested, to news about the economy.
Company-specific news affects the price of that firm’s shares, whereas news about the economy affects all of the market.
Good news about a firm that increases the stock price induces investors to sell. They’re selling winners.
In contrast, bad news about a firm does not induce investors to sell. They’re holding losers. You can see that investors are avoiding regret and seeking pride.
Are you an emotional investor?
Your financial life is affected by pride and regret if:
• You make important choices in spending or investing based on how much you have already outlaid.
• You generally prefer ‘safe’ investments, like term deposits rather than shares.
• You sell winners ‘to lock in profits’ rather than selling losing investments.
• You take money out of the share market (or are tempted to) when prices fall.
• You don’t sell losing investments, because you believe they’ll recover.
• You use naïve diversification – a loss hurts less if it’s combined with some gains.
• You talk long-term, but act short-term.
First published 13 September, 2018
This article is part of the Rational Investor series by Sheryl Sutherland. Sutherland, of the Financial Strategies Group, is an investment adviser who has worked in the industry for the past 30 years. She’s also the author of several best-selling books.
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