Advertisement
Investor Psychology

A Watched Portfolio Never Performs

The more you agonize over your investment portfolio, the worse you think it's performing ... even when it's doing really well.

Perception is reality when it comes to a portfolio.

Many investors feel like their portfolios are always underperforming. No matter how well diversified or how many best-in-class strategies they own, it rarely feels like they're making progress.

The reason it feels this way is the same reason a watched pot never boils: the observer effect. By simply looking at our portfolios, we are affecting our performance.

Advertisement - Article continues below

We are all aware of how making emotional decisions can destroy portfolio returns. But few are aware that how we mentally perceive performance can affect how we make investment decisions — even more so than the cold, hard facts.

Effects of prospect theory

The gap between performance and perceived performance is explained by prospect theory. Investopedia describes prospect theory as a phenomenon where “… losses cause greater emotional impact on an individual than does an equivalent amount of gain…”

This might be because fear is an absolute emotion and greed is a relative one. Fear is essential to our survival instincts and thus, we are inclined to draw out negativity to its worst conclusion. In the inverse, we expect good things to happen so we discount positivity. Even when things are the best and we’re comfortably in pursuit of greed, we are relatively certain that at any moment the other shoe is about to drop.

Advertisement - Article continues below
Advertisement
Advertisement - Article continues below

Whatever the explanation, this influence on investors’ psyches and their subsequent behavior can have a devastating impact on investment results.

The emotional experience of investing

The chart below shows how our perceptions, or misconceptions, can distort reality and create pain.

iStockphoto

It depicts a simple example of how an investor might experience prospect theory: The raw performance of the S&P 500 index is in solid blue. However, since each person’s emotional experience changes depending on how often they observe this performance, we demonstrate the likely emotional experience in the dotted lines.

The green dotted line is how an investor, according to prospect theory, will perceive the portfolio if they look at it monthly. The dark blue dotted line is if they look at it weekly. The red dotted line is if they look at it daily.

In reality, the S&P 500 appreciated by over 700% during this time period. Investors who checked their investment results just one time, after 23 years, would see this very large gain. Plus they would not have experienced any of the volatility (and corresponding fear or greed) along the way. In other words, these investors avoided the negative effects of prospect theory.

Advertisement - Article continues below

On the other hand, investors who viewed their investment results monthly, according to the theory, would have a very different emotional experience. Remember, the theory suggests that a 10% gain feels moderately good, while a 10% loss feels exceptionally bad. At a monthly frequency, over 23 years, that’s 276 opportunities for prospect theory to create negative emotions.

Advertisement
Advertisement - Article continues below

The impact gets much worse the more frequent the observations. This leads to a dangerous cycle between fear, greed and prospect theory: When things are good, performance is discounted, and when they’re bad, investors overreact. This skewed perception enhances fear or greed, leading to more emotional decision-making that seems to never pay off. Why? Because the good is never good enough and the bad feels worse than it actually is. And the cycle continues.

Cure the negative feedback cycle

Now, we know investors aren’t going to just ignore their portfolios. They might get notifications from CNBC and Bloomberg on favorite stocks. Major social, economic or political movements around the globe will still send investors rushing to check the effect on their portfolios.

Advertisement - Article continues below

But at least investors can be conscious of the enemy — their own emotions.

Despite the influx of information, there’s still an easy way to counter prospect theory: portfolio balance. The more balanced a portfolio is, the less volatility it’ll experience. Lower drawdowns mean less fear and greed, which of course means fewer emotional decisions and reduced effects of prospect theory. Awareness of this pattern helps, too.

Finding balance in today’s economy

Being aware of the benefits of true diversification and the damage that fear and greed can do is as crucial as keeping up with the financial news. Being aware of the games that prospect theory can play with the mind is nearly as important as choosing quality investments, at least if investors are seeking to achieve a balanced portfolio that helps them feel in control of their financial futures.

Otherwise, even when they’re making money, they’ll never feel like they’re keeping up with the Joneses.

Advertisement

About the Author

Stephen Scott, Investment Consultant

Managing Director, Longboard Asset Management

Stephen Scott is an alternatives and hedge fund investment veteran, with more than 25 years of experience in due diligence, risk management and index construction.

Advertisement

Most Popular

Social Security Recipients, Veterans Must Act Now to Get Extra $500 Stimulus Check
Coronavirus and Your Money

Social Security Recipients, Veterans Must Act Now to Get Extra $500 Stimulus Check

The deadline for seniors and veterans to request an additional $500 stimulus check for a dependent child is approaching fast. See how you can claim yo…
September 25, 2020
Trump Promises $200 Prescription Drug Card for Seniors
Medicare

Trump Promises $200 Prescription Drug Card for Seniors

Medicare beneficiaries will soon receive a debit card in the mail that they can use to pay for prescription drugs.
September 25, 2020
Election 2020: Joe Biden's Tax Plans
taxes

Election 2020: Joe Biden's Tax Plans

With the economy in trouble, tax policy takes on added importance in the 2020 presidential election. So, let's take a look at what Joe Biden has said …
September 18, 2020

Recommended

Bonds: 10 Things You Need to Know
Investing for Income

Bonds: 10 Things You Need to Know

Bonds can be more complex than stocks, but it's not hard to become a knowledgeable fixed-income investor.
July 22, 2020
Should You Retire During a Pandemic? 3 Things You Should Know
retirement planning

Should You Retire During a Pandemic? 3 Things You Should Know

You may have no choice but to retire early, so make these three crucial assessments now to see where you stand.
September 28, 2020
Check Your Financial Adviser Now (and Every Year) or Regret It Later
wealth management

Check Your Financial Adviser Now (and Every Year) or Regret It Later

Fewer than 10% of investors use such free background checks as Investor.gov, BrokerCheck or IAPD to check their financial advisers’ backgrounds. These…
September 21, 2020
HSA Limits and Minimums
health savings accounts

HSA Limits and Minimums

Annually adjusted contribution limits and other requirements must be met if you're covering health care costs with a Health Savings Account.
September 21, 2020