Excerpted from WSJ: The Mistakes We Make—and Why We Make Them. Aug. 23, 2009
Most investors are intelligent people, neither irrational nor insane.
But behavioral finance tells us we are also normal, with brains that are often full and emotions that are often overflowing. And that means we are normal smart at times, and normal stupid at others.
The trick, therefore, is to learn to increase our ratio of smart behavior to stupid. And since we cannot (thank goodness) turn ourselves into computer-like people, we need to find tools to help us act smart even when our thinking and feelings tempt us to be stupid.
- Investors tend to think about each stock we purchase in a vacuum, distinct from other stocks in our portfolio. We are happy to realize “paper” gains in each stock quickly, but procrastinate when it comes to realizing losses.Why?
Because while regret over a paper loss stings, we can console ourselves in the hope that, in time, the stock will roar back into a gain. By contrast, all hope would be extinguished if we sold the stock and realized our loss. We would feel the searing pain of regret. So we do pretty much anything to avoid that pain—including holding on to the stock long after we should have sold it. Indeed.
Successful professional traders … establish “sell disciplines” that force them to realize losses even when they know that the pain of regret is sure to follow.
- Goldman Sachs is faster than you. individual investors should never enter a race against faster runners by trading frequently on every little bit of news (or rumors) … Instead, simply buy and hold a diversified portfolio. Banal? Yes. Obvious? Yes. Typically followed? Sadly, no. Your ability to predict next year’s investment winner is no better than your ability to predict next week’s lottery winner. A diversified portfolio of many investments might make you a loser during a year or even a decade, but a concentrated portfolio of few investments might ruin you forever.
- Wealth makes us happy, but wealth increases make us even happier.John found out today that his wealth fell from $5 million to $3 million. Jane found out that her wealth increased from $1 million to $2 million. John has more wealth than Jane, but Jane is likely to be happier. This simple insight underlies Prospect Theory, developed by Daniel Kahneman and Amos Tversky. Happiness from wealth comes from gains of wealth more than it comes from levels of wealth. While gains of wealth bring happiness, losses of wealth bring misery.
- A stock-market crash is akin to an automobile crash. We check ourselves. Is anyone bleeding? Can we drive the car to a garage, or do we need a tow truck?
We must check ourselves after a market crash as well. Suppose that you divide your portfolio into mental accounts: one for your retirement income, one for college education of your grandchildren, and one for bequests to your children.
Now you can see that the terrible market has wrecked your bequest mental account and dented your education mental account, but left your retirement mental account without a scratch. You still have all the money you need for food and shelter, and you even have the money for a trip around the country in a new RV.
You might want to affix to it a new version of the old bumper sticker: “I’ve only lost my children’s inheritance.”
- Ask yourself whether the market damaged your financial security or only deflated your ego. If the market has damaged your financial security, then you’ll have to save more, or spend less.But don’t worry about your ego. In time it will inflate to its former size.
Full article:
http://online.wsj.com/article/SB10001424052970204313604574326223160094150.html
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