Take a Breath
Let’s say you finally bite the bullet and invest a nice little sum in a company you’d been hearing about for some time. All systems are go until one day the stock’s value drops a jaw-dropping 10 points. Do you run for the hills? The desire to get out (now!) is completely natural from a behavioral standpoint. But like other emotional impulses that hit fast — often without one iota of hard evidence to back up those butterflies in the belly — it’s probably wise to take a slow breath or two (or five) and ignore your gut instinct in this case.
In fact, our instincts and emotions can trip us up in many ways as investors, often without us realizing it. Here’s why — and what to do about it.
We’re Hardwired To Avoid Losing
The truth is, a person’s fear of losing $1,000.00 is roughly twice as extreme as the satisfaction we derive from earning that same $1,000.00, says Israeli behaviorist Shlomo Benartzi of UCLA’s Anderson School of Management. Psychologists call this “loss aversion,” and it is “a very powerful and common example in human decision making,” Benartzi writes in his book, “Save More Tomorrow.”
How does that play out in the market? Investors consistently tend to sell winning investments while holding on to losing investments — a behavior that’s also been dubbed the “disposition effect” by behavioral economists.
Loss aversion can prevent you from capitalizing on further gains in a stock that’s rising as well as benefitting from an investment that falls one day but later rebounds (as can happen when unexpected news or earnings that are slightly lower than predicted drive down the price temporarily).
We Tend to Follow the Pack
When a plumb investment suddenly seems to be going south, you might hear something on the news or from a friend that makes you want to take action before things get worse. Don’t. Keith Newcomb, CFP® and founder of Full Life Financial LLC in Nashville, Tenn., explains that when everyone’s listening to the same broadcasts and acting solely on the latest news, normally intelligent people may flock together like sheep, driven by — you guessed it — a common fear of loss. The thing is, this sort of “herding behavior” may not accurately reflect your investment target’s long-term prospects. Today’s news may be telling just a fraction of the full story — ignoring positive technicals and fundamentals that investors running with the pack are bound to miss, Newcomb says.
We Overreact to Media Reports
Newcomb recalls a panicked call he received from a client back in April 2013 when Microsoft dropped 5.25 percent after the stock was downgraded by Goldman Sachs and JP Morgan Chase. The client was watching the situation unfold on CNBC and wanted to sell. Newcomb advised otherwise. His technical analysis indicated that after “essentially going nowhere for 13 years Microsoft was in the early stages of a new long-term uptrend,” he said. Also, the 2013 downgrades were tied to a survey indicating that personal computer sales were dipping during the first quarter. Newcomb believed that Microsoft’s revenues were becoming “decoupled” from PC sales due to a shift to cloud technology and new income the company was making from monthly subscriptions versus sales of software in a box. Within a week, “Microsoft returned to its winning ways,” Newcomb says. On April 11, 2013, the price was 28.33 a share. Two months later it closed at 35.44, up 25 percent. On April 2, 2014, it traded at a yearly high of 41.66.