By Daren Fonda, Barron’s
Advanced imaging technology can pinpoint regions of the brain that light up when stimulated by fear and euphoria. But you don’t need a brain scan to see the market toying with those emotions: The Dow Jones Industrial Average plunged about 5,000 points from early October to Christmas last year, only to recover nearly 3,000 points in trading through Jan. 30, one of the biggest whipsaws in recent history.
Signals like this can be gut wrenching. Do you buy, sell, or do nothing? Should you ignore the noise and just be Zen? That’s fine if you’re a disciplined long-term investor, but it won’t help much if you’re paid to trade or make money for clients.
The field of behavioral finance offers a few answers. For one, it’s well established that investing is an emotion-laden act (even for the quantitative-minded). Much of our emotions and feelings about the market are driven by brain biochemistry. And we have no choice but to live with this software — evolved over millenniums going back to our ancestry in the African savanna. Unfortunately, the same instinct that saved your forebears from lions won’t help you escape getting killed by a bear market.
It’s not all bleak, though. By recognizing how emotions can lead them astray, investors can take steps to protect themselves from their worst impulses. Financial advisors can play a crucial role — some say it’s their most important role — by coaching clients to understand their inner selves and avoid investing mistakes.
Many financial firms are training advisors to be more like therapists and coaches. At U.S. Bank Wealth Management, candidates for advisor jobs take a personality test, partly to see how empathetic they would be with clients, says Daniel Farley, a market leader with the firm.
Vanguard is encouraging advisors to view behavioral coaching as a key service. “Advisors should know that their job is to understand the people they’re working with, not just build portfolios,” says Donald Bennyhoff, a Vanguard senior investment analyst who focuses on coaching techniques.
Unfortunately, it’s not an exact science. There’s scant scientific evidence to identify an intervention or coaching technique that always works, says Brad Barber, a finance professor at University of California, Davis. It’s like trying to find a singular cure for cancer; genetic variations are so vast that everyone needs a personalized remedy.
With those caveats in mind, we asked leading experts in behavioral finance for tips on recognizing our behavioral tripwires and how to prevent them from blowing up our portfolios.
1. You Hold Losers Too Long
Many investors can’t seem to part with money-losing stocks. That type of behavior — well documented in academic studies — can be quite costly. According to a 1998 study of 10,000 accounts at discount brokerage firms, the average return of winners that investors sold was 3.4% higher over the next year than the return of the losers they held on to.
One solution is to ask yourself why you keep clinging to a losing stock. Is it because you truly believe it’ll rebound, based on new information? Are you reluctant to sell because that would mean admitting it was a failed investment?
Consider reframing a loss as an opportunity, says Hersh Shefrin, a pioneer in behavioral finance at Santa Clara University. View a loss as a “transfer of assets” from stocks that have gone down to stocks or funds that make sense in the current environment, he says. “Avoid the phrase ‘selling your losers’ because that makes you feel like a loser. Winners transfer their assets.” Remember: A tax-loss is an asset from an accounting point of view. Don’t squander it, harvest it.
2. You Sell Your Winners Too Soon
If you have some paper gains, the temptation to sell and lock in profits may be powerful. This can overwhelm the tug of the endowment effect (believing what you own is more valuable than it really is). But many studies find that investors are more likely to sell assets that have gone up than those that have declined — a tendency known as the “disposition effect.”
One way to avoid disposition bias is to obscure the purchase price of a stock on your trading screen, say by changing the screen view to hide your cost basis. The more salient the purchase information, the more likely you are to trade, and “manipulating the salience of information can improve trading performance,” says Cary Frydman, a behavioral economist at the University of Southern California who has studied such effects.
Focus on more relevant information — whether you think a stock or fund still has good long-term prospects and whether you have some informational advantage that everyone else is missing — rather than things that aren’t relevant to performance, like the price you paid or its role in your portfolio.
3. You’re Overconfident and Take Excessive Risks
Many investors overestimate their skills and underestimate external risks, says Cornell University behavioral economist Vicki Bogan. Investors may believe that they can outsmart the market by picking individual stocks (most studies say that’s unlikely). They may also be overly optimistic about the prospects for stock returns, resulting in too much equity exposure in a retirement account.
If you pick stocks or use actively managed funds, do so with an amount that won’t heavily affect your retirement, says Barber. Maintain a small “gambling” account to scratch the trading itch. And avoid the temptation to trade often. “There’s a reason there are no chocolate-chip cookies in my cupboard,” he says. “I’d eat them if they were there.”
If you tend to underestimate risk, look for media stories or analysts with the opposite point of view, says Shefrin. Leading bearish strategists these days include Albert Edwards, David Rosenberg, and Nouriel Roubini. “If overconfidence leads us to take imprudent risks, then a little more emphasis on gloom might induce us to be a little more prudent,” he says.
4. You Tend to Wing It and Focus on the Wrong Cues
Many of us (journalists included) aren’t systematic in how we invest. And we constantly seek explanations for the chaos around us. We look for patterns that represent the past (“This is just like the dot-com bust!”), confirmation of our prior theories (“I knew the market was heading for disaster”), or signs of a streak (like a “hot hand” at the blackjack table). Mostly, we wind up with false insights, prompting us to trade on distorted data points or headline-grabbing events.
If you find yourself batted about by market signals, consider playing Moneyball with your account: Take a hard statistical look at your investments, and probe what you’re getting right and wrong, says Terrance Odean, professor of finance at the University of California, Berkeley. “It’s amazing how much investors kind of wing it,” he says. “Individual investors tend to be really swayed by what catches their attention. My advice is to study what you did and didn’t do, keep records, and look at what’s working.”
5. Stocks Are Tanking and You’re Itching To Sell
Rather than making the mistake of selling when things look bleak, reward yourself for not acting impulsively. A psychological trick that works for exercise could help; instead of focusing on the pain of hitting the gym, substitute a reward for a good workout, like getting a massage or lining up a date night with your spouse. It’s easy to pay lip service to the idea that recent history won’t last, but convincing yourself is harder. We’re all prone to recency bias — expecting the latest trends to continue. And it’s hard to tolerate short-term pain in exchange for a reward that will come many years from now (like a higher retirement account).
It’s also helpful to put recent turmoil in context. Shefrin recommends quizzing yourself on market history: What’s the longest bull market in history or consecutive days of stock gains? You’ll probably find comfort in knowing that market dips and volatility are quite common historically. Make a trivia game of it and play with friends; whoever gets the right answers doesn’t pay for the beer.
If all else fails, stick a Post-it note on your computer with Warren Buffett’s advice: Be greedy when others are fearful. Market declines never turned him into an ostrich. If he racked up losses, they didn’t get him down. Instead, he seized the opportunity to buy stocks when they were on sale.
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