Broker Check

How human nature effects investing

February 18, 2014

Investor emotion usually works against investors.  We have all heard that fear and greed control the market.  Those are also the two major emotions that cause people to make poor investment decisions.

Take a look at Abby. Like any other investor, she wants to get the most out of every dollar so she looks for investments that have historically done well and that she feels will have a good chance of doing well in the future.  She heard some of her friends talking about this company that has been doing very well lately and she decides to check it out.

After careful examination, she decides she wants to invest in this company and purchases 1000 shares at $10 per share.  Over the next week, she sees the share price go up to $13.  Very happy with her choice she decides to purchase another 1000 shares now at $15.  A month later the price has now gone from $15 to $20 per share.  Not wanting to miss out on this amazing upswing she purchases another 2000 shares.

Abby has now purchased 4000 shares of a company that she thought was a good buy at $10 per share and now that she has seen its great performance she believes it is a great buy at $20.

The next week there is a pullback in price to $19.  Believing in the performance she has seen says to herself that it’s just a blip in and that it will come back.  The next week the price falls again to $18.  She understands this is a lower price than she had expected but she feels compelled to stand by the company that has done so well for her.

When Abby next sees the price at $17 she starts worrying about all of the money she has put into this company.  Abby remembers hearing about disciplined investing and decides to draw a line in the sand.  If the share price falls to $16 she will sell.  After all, she got in at $10.

Sadly the price does drop to $16 and Abby sells all 4000 shares.  Let’s take a look at how Abby came out.

What emotions caused Abby to lose money on such a well-performing stock?  She wasn’t being greedy, was she?  How about fear?  It doesn’t seem like she panicked.

Fear and greed are terms that are often used to describe the reasons for the up and down movement of market prices.  The reality is that every price has countless forces moving it.   These emotions are only two.

We can examine the cycle of investor emotion in the chart.   In a diagram copywritten by Westcore Funds investor emotions have been pegged along a wave of market activity showing in greater detail how they hold back investors from making the right decisions.

How can you use this knowledge to your advantage?  Take emotion out of your investment decision making process.

One way to do this is to follow an investment plan that spells out what investments you should make and when.  If you are making individual investment decisions you can use an investment policy statement (IPS).

An IPS is a set of rules you set for yourself before making an investment that will allow you to make investment decisions without emotion.  It spells out why and how you buy or sell certain investments.

If you don’t have a plan or an IPS then talk with an advisor to formulate one for your situation and follow it.

Questions or suggestions for a future topic please call or write 240-720-5153  [email protected].

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