Investor Psychology

The High Cost of Emotion in Personal Finance

Our rational side knows market timing is a fool’s game. Yet, short-term trends sometimes drive our decisions.

Humans are hard-wired in ways that helped our ancestors survive over thousands of years. Investing in markets is a recent concept – the New York Stock Exchange (NYSE) was founded in 1817. Unfortunately, the cognitive processes that aided our ancestors may undermine our success in modern markets. Behavioral finance is an emerging field that examines how people use the tools of finance, rather than studying the tools themselves.

One common behavioral mistake is known as “myopic loss aversion.” Behavioralists have estimated that people hate losses roughly two-and-a-half times as much as they like gains. We exert more effort to avoid losses than to achieve gain. Suppose an investor’s portfolio rose 40% and then dropped 20%. He/she would feel the loss about 2.5 times as much as the gain. The drop causes heightened loss aversion, potentially leading the investor to panic and act against what he/she knows is rational.

2015

Thinkstock

Researchers measured the cost of this approach by comparing the performance of return chasing with a buy-and-hold strategy. The research reveals return chasing leaves nearly 2% on the table annually. Rather than earning 10% annually over the long term, those impaired by the recency bias took a 20% haircut and ended up with 8% annualized returns.

Understanding the lessons of behavioral finance can greatly increase your odds of achieving financial freedom. Realizing that these tendencies exist is the first step in making better decisions. Remember, we hate losses roughly two-and-a-half times as much as we like gains. Fight the urge to panic over investment losses, and realize our tendency to overreact to recent history. Working with a financial adviser can help you stay on track. It’s easy to get emotional when managing your own money. An objective partner can help you overcome harmful behavior biases and remain focused on long-term goals.

Sources: Bloomberg, CFA Institute, Wall Street Journal, About Archeology, Federal Reserve Bank of St. Louis, Investment Company Institute, Morgan Stanley International

David has served as CEO of Mercer Advisors since 2008. He is responsible for the firm’s strategic vision, business plan execution, and organizational structure.

About the Author

David H. Barton, CEO

President & CEO, Mercer Advisors

David began his career at Mercer Advisors in 2000 as General Counsel, was promoted to President in 2004, and became Chief Executive Officer in 2008. He is responsible for the overall strategic vision, business plan development and execution, and organizational structure at Mercer Advisors. David earned his degree in Political Science from University of California, Irvine, and his Juris Doctor from the University of the Pacific, McGeorge School of Law.

Most Popular

Where's My Stimulus Check? Use the IRS's "Get My Payment" Portal to Get an Answer
Coronavirus and Your Money

Where's My Stimulus Check? Use the IRS's "Get My Payment" Portal to Get an Answer

The IRS has an online tool that lets you track the status of your stimulus checks.
February 19, 2021
Want More Tax-Free Retirement Income? One Man’s Whole Life Decision
life insurance

Want More Tax-Free Retirement Income? One Man’s Whole Life Decision

Whole life insurance might not be something that’s on your retirement planning radar, but for this client, here’s how it served his need to control ta…
February 23, 2021
The Current Plan for $1,400 Checks
Coronavirus and Your Money

The Current Plan for $1,400 Checks

Here's what you need to know about the stimulus check plan currently being considered in Congress for President Biden's COVID-relief package.
February 18, 2021

Recommended

Why I’m No Fan of Trading Apps That Treat Investing Like a Game
investing

Why I’m No Fan of Trading Apps That Treat Investing Like a Game

In the wake of the GameStop saga, an investment professional shares his take on the rush of people buying into “hot stocks” only to get into hot water…
February 24, 2021
Lump Sum or Not: What’s the Best Way to Invest Your Year-End Bonus?
investing

Lump Sum or Not: What’s the Best Way to Invest Your Year-End Bonus?

What is dollar cost averaging, and when you have a significant windfall to invest, which method is better for you: dollar cost averaging vs. a lump su…
February 17, 2021
Is the Stock Market Open on Presidents' Day 2021?
Markets

Is the Stock Market Open on Presidents' Day 2021?

If you invest in the stock or bond markets, enjoy your Monday off. The markets will be closed in honor of George Washington's birthday.
February 13, 2021
What Exactly Is a Short Squeeze?
investing

What Exactly Is a Short Squeeze?

A short squeeze is a quick path to getting a lot of juice out of a stock. We explain the phenomenon, and the short selling that fuels it.
February 11, 2021