The Hulbert Financial Digest estimates that mutual fund investors lost $42 billion more than they should have during the 12-month period that ended last May.
How could this have happened? The simple answer is that emotion, not logic, usually rules our investing habits. In many ways we're predisposed not just to buy high and sell low, but to cling to losing investments we should sell, ignore threats to our wealth and follow the investing herd off a cliff again and again.
But just recognizing our mental kinks won't help us undo them, experts say. "I don't believe it's possible to change behavior that's really hard-wired into our biology," says Andrew Lo, director of the Massachusetts Institute of Technology Laboratory for Financial Engineering. But "Homo sapiens can do what we've always done: adapt. We don't have wings, but we can fly. So we develop tools to protect ourselves from these emotional shortcomings."
The silver lining to the recent bear market is that painful experiences remain in our memories for a long time and provide lessons for the future. So let's review the past few years through the eyes of experts in investor psychology and behavioral finance, studying events not as a financial roller coaster, but rather as an emotional one.
As a result of the recency effect, says Davies, "what's most recent in our minds stands out." For instance, "if investments have been going up for a while, I start seeing them as less risky. I start thinking, Well, my budget for risky investments isn't full -- I can put more in there."
For many people, plunging portfolio values became too much to bear, and they just wanted the pain to end. So they sold. According to the Investment Company Institute, the greatest net monthly outflow from stock funds in the past two years -- $25 billion -- came in February 2009. The timing couldn't have been much worse for those who sold then. As it turned out, stocks bottomed on March 9 and surged about 50% over the ensuing six months.
So, if you recognize yourself in some of the actions (or lack thereof) we've just described, now's the time to take steps to make sure you don't suffer the same mental miscues in the future. You may not be able to change your behavior in trying times, but you can change your investing strategy to neutralize negative impulses.
One bold idea: If you handle your own investments and you find that emotions are tripping you up, hire an adviser. A good adviser should help you avoid those impulses-which typically stem from short-term fluctuations in the value of your investments-and keep you focused on meeting long-term goals. The extra cost could be worth the money.
Read the article at Kiplinger's
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