How investors behave when exposed to real-world events is an emerging field of study. While not as data-centric or numeric as securities analysis, behaving "well" as an investor is important. This page summarizes some behavioral recommendations and pitfalls.
Let's start on the positive. If you use low cost index funds, select a financial advisor based on reason and not just relationship, don't overpay your financial advisor, rebalance in a smart way, and don't fall prey to behavioral errors, you are making sound behavioral decisions.
Look-back regret can form easily, and it can waste your energy and time. For example: say you pick individual stocks, and you owned Priceline but sold it when it was trading at $8 a share, not anticipating its rise to $1,400. Or if you owned RIM Blackberry, convinced the Blackberry was on the path to world domination, and it went from $218 to $7. The emotional toll and mental fatigue may be large. Buying index funds avoids this "could-we would-we should-we" mental drag.
Related to the item above, you will want to do what you should have done two years ago. The temptation is to buy stocks when they are high, not when they are low. Further temptation tempts you to sell when they are low, not when they are high. This inclination to act at the wrong times is destructive to returns.
"One cannot help being amazed how much money investors repeatedly lost and how violent 19th century recessionary periods were. The most striking characteristic is that they were latecomers to an investment fad."
- Marc Faber, Tomorrow's Gold
Investors suffer from the tendency to want "social inclusion." Since you were a child you have been trained by society that there are benefits to "staying with the herd," that there is protection in a large group of people. It's normal to want to buy at the same times, and the same investments, as other people.
"If you wait for the robins, spring will be over."
The human mind tends to overweight near-term historical experiences and underweight the long term. This makes it easy to lose sight of the long-term investment picture.
Seth Klarman, a hedge fund manager in Boston, pointed out: if you lose 70% of your money in an investment, emotionally that feels like losing 100%. Think about having $100 dollars and ending up with $30. You are going to feel awful. You are not going to take the attitude of "well, at least it's not zero."
It is hard to know how you will behave when a sense of panic builds in your mind. In a severe crash, if you have lost 40% of your assets, you might not be thinking "No biggie, I'll just play tennis until the market recovers." You may be reading news stories that reference the Great Depression. Neighbors may talk about switching to gold bullion, and your wayward uncle may be hoarding food, water, and batteries in his basement.
"Nowhere does history indulge in repetitions so often or so uniformly as in Wall St. When you read contemporary accounts of booms or panics, the one thing that strikes you most forcibly is how little either stock speculation or stock speculators today differ from yesterday. The game does not change and neither does human nature."
- Edwin Lefevre, in 1923 (Devil Take the Hindmost)
This is purely an observation from my experience. I've noticed that people who have a major investment success early on are in for a rough ride later. The perception in their minds is formed that they can outsmart the markets, and it takes many painful failures for this perception to be reset.
Gambling is a powerful force, and the securities markets can be addictive. If you have ever had a problem with gambling, index funds are critical to avoid the temptation of the securities "casino."
"The psychologies of speculation and gambling are almost indistinguishable: both are dangerously addictive habits which involve an appeal to fortune, are often accompanied by delusional behavior and are dependent for success on the control of emotions."
- Edward Chancellor, Devil Take the Hindmost, page xi
Jealousy is a powerful force, and investing breeds it. A neighbor who bet on the right small-cap company that soars may start buying luxury cars and fancy vacations. This can influence you to behave the same way.
"It's not fear and greed that drive the investment world: it's envy."
- Warren Buffett
Financial news channels should be avoided. If you want to be entertained, go to a movie or set an exercise goal. Watching financial news is going to sway your emotions in ways that are not beneficial. If you're on a golf course, try not to talk about stocks. (Talk about this girl who took out a drone with her driver instead).2
"It's no wonder that, as brilliant research by the psychologist Paul Andreassen showed many years ago, people who receive frequent news updates on their investments earn lower returns than those who get no news. It's also no wonder that the media has ignored those findings."
Politics and investing are a bad mix. Like most of us, you may get emotional when politicians you like or dislike are elected. Tying those emotions to your investments is a risky proposition. There are millions of variables that form securities prices, and the political issue on your mind is only one of them.
We're going to end on a positive. We have found that people can train their minds not to worry about finance and the markets. If you pay less attention to the markets, they recede in importance in your mind. You may just start to forget about them. Turns out, as this paper showed, not paying attention has benefits!4
