August 11, 2011
How Emotions Drive Investing
With the Standard & Poor’s 500 stock index down 13 percent in three weeks, new research confirms what many people believe to be true: emotions drive investment decisions that can lead to costly mistakes.
In a forthcoming paper in the Journal of Market Research, three business professors were able to show for the first time that an investor’s prior experience with buying and selling a company’s stock – not cold, hard analysis – is what determines whether he or she would repurchase that same stock at a later date. When the entire market plunges hundreds of points, as it has this week, the tendency to be led by one’s emotions is only magnified.
Money-losing stocks are “associated with disappointment and regret,” the researchers wrote. “Simple reinforcement learning deters them from repeating the behavior that previously caused pain.”
Their paper, “Once Burned, Twice Shy,” adds to a growing literature that attempts to clarify the psychology of financial behavior. It’s a twist on one classic study that determined that people feel the pain of financial losses – or “regret” – far more acutely than they feel the joy of gains. Other studies have firmly established that investors more often sell winning stocks than losing stocks.
To demonstrate the power of emotions, the new study’s co-authors – Michal Strahilevitz at the Ageno School of Business at Golden Gate University; Terrance Odean of the Haas School at the University of California, Berkeley; and Brad M. Barber of the Graduate School of Management at the University of California, Davis – examined data from brokerage trading accounts for more than 650,000 individuals between 1991 and 1996.
They analyzed transactions in which an investor repurchased any stock that he or she had sold in the past. Stock-repurchase data are a neat way to analyze emotional investing because they are a window into how investors react to their own prior experiences.
The researchers found that investors are far more likely to repurchase stocks they once sold for a profit than to repurchase stocks they once sold at a loss. They’re also reluctant to repurchase stocks that rose in price after they sold it. That represents money they didn’t make – another type of “regret.”
In the current stock market, investors who pull out are effectively doing the same thing by abandoning “rational” investment strategies, which were well-thought-out and continue to make sense, Strahilevitz said.
“It’s very hard to predict when the market will go up and down. If you based your investments on rational decisions, such as diversification and not being over-exposed to risk, then selling every time you’re scared isn’t going to pay off,” she said.
The point of the paper wasn’t to analyze the impact on investment performance. However, the researchers did find that performance in one case suffered when investors acted on their emotions.
Squared Away is eager to hear comments from investors or financial planners about how they or their clients cope with the emotional ups and downs of today’s gyrating markets.