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How Emotions Undermine Your Investing Decisions

January 25, 2011

by Dan Richards

How did you gather that data?

We looked at data from 1991 to 1996 from a large discount firm and data from a standard retail brokerage firm in a more recent time period.  These were actual trading records of investors who were managing their own portfolios.

Someone has bought a stock at one point, sold it again, and they could have a couple of different kind of experiences.  They could have made money.  They could have lost money.  Did you see a difference in terms of their subsequent behavior, based on whether they lost or made money the first time around?

Absolutely.  We were studying how investors’ emotional experiences affected things.  Obviously, if you bought a stock and you sold it for a gain, it is a great emotional experience.  You feel like you are a wonderful investor.  If you bought a stock and sold it for a loss, you don't feel so great about it, and probably want to put the experience behind you.

What we found was that, subsequent to the sale, investors were much more likely to buy a stock again had they previously sold it for a gain.  The story that we tell is that if you've had a good experience with a stock you are more likely to revisit that stock in subsequent purchases.  In fact, it was very rare in our data set that folks come back to buy a stock that they have sold for a loss.

What if someone sold a stock, but then the stock subsequently went up or down?  Did you see a difference in investor behavior in those cases?

Absolutely.  And again, our story centers on emotions.  So imagine you sold a stock, and imagine that after the sale it goes up tremendously.  Well, you are not going to feel very good about buying the stock again because you've missed out on that appreciation, having previously sold the stock. 

On the other hand, if you sell a stock and it goes down, you might look and say well, I was really good at timing the sale of that stock, and it is a good opportunity to repurchase the stock.  That is exactly what we found.  In other words, if they sell a stock and the price goes down, investors are much more likely to buy the stock again than if they sell a stock and its price continues to go up.

Were you able to quantify the experience of those investors?

The details are in the academic paper of course, and we try to make sure that our story is the right story.  One of the competing stories is, maybe the investors who sell stocks for a gain are smart. They know how to time the market well, and they buy the stock again when it's down.  They are really informed.

In order to discount that potential explanation, we had to look at how an investor’s purchases and sales did subsequent to the date of the transaction.  In general, we found that these investors don't have any market timing or security selection ability.  The stocks that they subsequently purchase after they have gone down in price don't do any better than buying an index fund, for example.  So it doesn't look like these investors are informed, but rather it's just an emotional reaction to the price path of the stock that leads them to buy the stock again.

Based on this analysis and research, what is your advice to investors?

My advice has been the same for the last decade: Buy well diversified, low-cost index funds as a core of your portfolio.  I think the profession is very much on the same page on that. 

Most of my research centers around the emotions and psychology in investing, and in fact those things get in the way of doing what seems to be a sensible thing – have a well diversified portfolio, hold it, don't spend a lot of time thinking about it, and enjoy your life.