Jewish World Review Sept. 28, 2004 /13 Tishrei, 5765
By Jeff Brown http://www.jewishworldreview.com | Most people have heard of the psychological stages of dying - anger, denial, bargaining, and so on.
What about the psychological stages of investing?
Here they are. Imagine two humps on a camel - a graph of stock market performance, from high to low and back to high.
Start at the top of the hump on the left. As you move down the slope, prices are falling and you experience apprehension, then fear, then panic.
Then, as prices rebound and head for another peak, you go from excitement to exhilaration to euphoria.
OK, that's nice. So what?
Here's what: By acting on emotion rather than reason, many investors do exactly the opposite of what they should. As panic sets in, they sell at the bottom. And as euphoria takes over, they buy. They sell low and buy high.
"This curious departure from rational behavior occurs because investing is an emotional experience," says Davis Advisors, a Tuscon mutual fund company, in a recent report titled "The Successful Investor.''
"Put simply, people "feel more confident and thus invest more when prices are high, just as they feel more pessimistic and are tempted to sell when prices are low."
Obviously, it's better to buy during periods of pessimism and sell in times of optimism, but that's not easy. Davis' advice is to hire professionals who can keep their emotions in check.
But the do-it-yourselfer with a modest portfolio should be able to manage fairly well, too.
The first step is to really believe that this buy-high-sell-low pathology can happen to you. The Davis report mentions a study by a Boston research firm called Dalbar.
It found that from 1984 to 2002, the average stock mutual fund racked up returns averaging 10.2 percent a year. But average investors didn't do nearly as well. They made only 2.6 percent a year because they didn't hang on through thick and thin. They bought "hot" funds "after they did well, and sold "after they did poorly.
Put another way, $10,000 invested in the average fund should have grown to $63,600, but the average investor's portfolio grew to only $16,300.
Indeed, the average investor "lost money once inflation was taken into account.
Many investors, if not most, rely on brokers or other financial advisors. So the Dalbar study shows the pros are as infected by the buy-high-sell-low pathology as individuals are.
If you followed the "buy" advice of Wall Street analysts during the tech stock bubble of the late '90s, you know what I mean.
Looking back, it's easy to say you should control your emotions. But at the time, emotions are fueled by uncertainty. When stocks are down, you don't know if they're at the bottom or will continue to fall, so selling seems like a rational way to cut your losses.
Same goes for the upswing. After all, every peak is preceded by a period when stocks were up, but not so far. Sell then and you'll miss the profits to come.
Reduce the effect of emotion by limiting the number of decisions you have to make.
Small investors probably do best with automated investing - putting the same sum into the same fund or set of funds every month.
Most 401(k) investors do this, and it's easy to set this up for an ordinary account as well. Ideally, get your employer to automatically deposit your pay at your bank, then give your brokerage or fund company authority to automatically draw a set sum from your account every month.
Plan to keep your money invested for a long time - five to 10 years, at least. And during the downturns, just think about the bargains you're buying.
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Jeff Brown is a business columnist for The Philadelphia Inquirer. Comment by clicking here.