Investor behavior – How human nature can effect investing
February 12, 2014
Emotion usually works against investors. We have all heard that fear and greed control the market. There are many emotions that cause people to make poor investment decisions.
Look at Abby. Follow her emotions around the wheel while thinking about how you would feel.
Like any other investor, Abby wants to get the most out of every dollar. 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 optimistically decides to check it out.
After careful examination, Abby 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. As her enthusiasm grows about 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. Wanting to get the most out of this exciting 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 exhilarating 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 is just a blip 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. If your emotions contribute to how you interact with these prices they could be doing you more harm than good.
We can examine the cycle of investor emotion in a diagram I adapted and designed from several sources and years of investor interaction. With Some clients, I can tell you how they will emotionally react to a change in prices of their investments. Investor emotions often correlate to price along with this circular pattern. How can you use this knowledge to your advantage? Take emotion out of your decision making process.
One way to do this is to follow an investment plan that spells out what investments you should make, when and why. If you are making individual investment decisions you can use an investment policy statement (IPS).
An IPS is a set of rules you apply to your investing behavior before making an investment. It will allow you to make investment decisions without emotion. The IPS spells out why and how you buy or sell certain investments. If you follow it you can avoid costly emotional mistakes.
If you don’t have a plan or an IPS, talk with an advisor to formulate one for your situation and follow it. Please remember Abby's situation is presented for educational purposes and fictitious. Each person's situation is unique and past performance does not guarantee future results.