After the devastation in the markets and exchange traded funds (ETFs), it’s worth a look back on what aspects of investor behavior contributed to portfolio losses, anxiety and regret.
Emotions tend to supersed logic as markets worsen, leading many investors to cling to losing positions. We saw this most recently this year and last year, remarks Bob Frick for Kiplinger. One way to prevent this from happening again is to examine where things went wrong. (Read more on emotions here).
Frick outlines some of the key areas where investors may have stumbled as presented in Nudge: Improving Decisions About Health, Wealth and Happiness, by Richard Thaler and Cass Sunstein.
- Stories. As in the internet and real estate bubbles, investors tend to organize facts around stories that are greatly exaggerated or sometimes false (such as, “Real estate always appreciates”). This thinking can give people confidence and inspire them to take on more risk.
- Confirmation bias. We tend to focus on facts that support our “story.” For example, in the property boom, people looked at the rising prices but ignored the fact that supply of houses could outpace that of demand.
- Recency effect. Before the collapse, investors were lulled into a false sense of complacency and began to lose their sense of caution, according to Greg Davies, head of behavioral finance for Barclays Wealth. This is because for several years, they hadn’t known anything but gains.
- Herd behavior. This is the belief that “If something is safe for everyone else, it must be safe for me.” Many jump into bubbles, enjoying the happy feelings brought on by rewards. These feelings often overshadow nagging signals we receive from our fear centers, says psychiatrist Richard Peterson.
- Ostrich effect. When everything is falling apart, investors often will try to ignore reality and turn a blind eye to their accounts. On the other hand, in good times, many investors tend to check their accounts far more frequently.
- Disposition effect. This is the belief that if we don’t actually sell a stock that’s taken a hard hit, we’re not acknowledging the loss and pain that accompanies it. If you don’t take the loss, goes the thinking, it’s not a real loss.
- Risk. Be aware of the level of risk you’re comfortable with. A stable portfolio may help you make decisions through logic rather than emotions.
- Diversification deficit disorder. Investors need more than just stocks and bonds. Try to step outside of the regular mix of stocks and bonds, with assets such as real estate, commodities and other alternatives.
One way to manage emotions is to have an entry and exit strategy. We use the 200-day moving average, which you can read more about in our book, The ETF Trend Following Playbook.
For more information on investing, visit our ETF 101 category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.