Friday, March 28, 2008

Investor Psychology: Why Can’t We Accept Losses?

I read an article in the New York Times yesterday that made me think of investor psychology. The following is an excerpt:

“...dropping the asking price below their purchase price—is especially difficult. It’s tantamount to admitting defeat. David Laibson, a leading behavioral economist, categorizes this sort of behavior under the heading of ‘the principle of the matter.’ His point is that people often go to great lengths to avoid taking a loss—or simply having to acknowledge one. ‘Even a small loss evokes a sense of frustration,’ said Mr. Laibson, a professor at Harvard. ‘There’s something magical about at least breaking even.’”

Laibson is so very right in his diagnosis. I know that when I see one of my investments losing value, and all signs suggesting things will only get worse, pulling the plug is one of the hardest things to do. For some reason, we would rather keep a bad investment in hopes that it will miraculously turn around than move on to things that could be more profitable. It is common for investors to keep their poor investments too long and sell their great investments too soon. This is one reason why it is said that most people are better off investing in index funds than choosing their own investments.

Last year, NuWire released an article about investor psychology. It was interesting to look back at that article and reflect on my own investment decisions. Looking at them now, I can see many mistakes that I’ve made—selling certain investments too soon, holding onto others too long. I’ve certainly not proven to be an exception to the rule, even though I like to think that I evaluate potential investments more on data and facts than emotion.

I think that, in an effort to avoid being wrong, we make allowances for our poor investments. It is certainly easier, and much more exciting, to sell off an investment that made money than one that lost money. And who wants to go talk to their investor friends about this bad investment they just got out of? Not I. We prefer to revel in the glow of our victories and sweep our failures under the rug, hoping that someday we will lift that rug up and find a pleasant surprise.

To help combat this problem, one suggestion I have is to make an effort to solicit outside advice from trusted investors. They won’t have the same attachment to the investments that you do, and they could be better equipped to come to a rational, objective solution. Even being able to talk with others about your failing investments is a good step towards recovering. Sorry if that makes it sound like an AA meeting for investors. A good investment club might be a great resource to find people for this type of thing. You can help them, and they in turn can help you. If anyone has other ideas on how to combat negative investor psychology, I would welcome the discussion.

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