With the recent markets heading lower, I thought it would be a good time to run an article on why investors act the way they do in a downward trending market.
The Psychology Of A Loss
In a downward trend it is easy to get caught up in the short term emotions of the correction and lose sight of our long term goals. If our goal is to build a portfolio of high quality dividend paying stocks that frequently raise their dividends, we must not allow ourselves to be influenced by the market behavior over a short period of weeks or months.
Investors are often influenced by short term downward movements in the market, not wanting to see their hard-earned cash lose value as the markets tumble. This theory has been studied by scientific researchers Bernatzi and Thaler, who named the phenomenon “Myopic Loss Aversion”. You can read a great article about the development of Myopic Loss Aversion in the Quarterly Journal of Economics from February 1995. the theory makes logical sense and is, in my opinion, very relevant today.
We’re Naturally More Sensitive To Losses Than Gains
The tendency for investors to be about twice as sensitive to losses as we are to gains has been extensively studied by behavioral finance pioneers, Amos Tversky and Dainiel Kahneman and is called “Prospect Theory”. This theory also makes intuitive sense, especially for me. Human behavior is a funny thing; we always want more, but we don’t want to lose what we already have.
In essence, we are naturally risk averse and are pre-conditioned not to understand the basic relationship between risk and reward. Does this theory hold true for you?
Lets ask ourselves a couple of questions and see!
- What was your general feeling about your investments over the past few years?
- What has been your general feeling over your investments over the past few weeks?
- What has changed with regard to the fundamentals of your stocks over the past few weeks?
- What has changed about your overall investment goals over the past few weeks?
After answering these questions honestly, take a look at them and see if the answers are congruent. If your emotions have taken over and have gotten the best of you, as mine sometimes do you will notice that your answers to these questions will not align with your long term investment goals.
Will you let your emotions get the best of you? I hope not…I don’t want to see you hurtling toward the earth from your office window.
As a friend of mine has said:
The eggs are on sale…let’s look for buying opportunities!