Today I have a guest post from Anum Yoon, who’s a personal finance blogger and journalist who runs Current on Currency. Check out her blog to read her thoughts on investing, saving for retirement, and budgeting.
Trying to control the stock market is already an impossible task, but did you know your brain is actually working against you when it comes to investing?
Your mind works to protect you from risky behavior, including taking high risks, getting out of an investment early and refusing to buy a profitable stock back.
Recent research conducted by Cary Frydman, Assistant Professor of Finance and Business Economics at Marshall School of Business at the University of Southern California, suggests people from every economic social class make financial decisions against sound principles due to cognitive processes.
The Disposition Effect
Some investors consistently sell stocks that increase in price and keep stocks that are tanking in hopes that they will resurge. This practice is called the disposition effect. Frydman studied the brain functions of investors through an fMRI machine — functional magnetic resonance imaging machine — for these results.
She discovered that, while the investors were trading for gains, the sections of their brains in charge of pleasurable feelings would light up. Investors who didn’t trade their rising stocks did not experience these changes. This finding suggests people selling their stocks for gains can become addicted to this pleasure feeling, similar to hedonic behavior.
The problem with seeking this type of pleasure “hit” is that you might lose out on future gains and pay tax on your sold shares. This behavior runs contrary to market information, sound financial advice and tax benefits.
Holding a winning stock longer through the ups and downs of the market can result in higher profits long-term. You may feel that giving up on a losing stock is some type of betrayal, but cutting those losses early can save you money and free you to invest in other stocks.
The Repurchase Effect
Frydman also studied the participants when a stock they had already sold increased in price. The parts of the brain that signal regret lit up on the fMRI machine when the investors observed the return. Although it would be in the investor’s best interest to repurchase the stock, the participants in the study refused to reinvest.
According to Frydman, the feeling of regret is so great it results in decision paralysis, in which the participant cannot repurchase the stock and must watch it continue to climb higher without their investment. Participants felt the same way about stocks they almost purchased but decided not to invest.
This deviation from the predictive model shows the information-processing portion of the brain gives way to irrational behavior. Investors who exhibit the repurchase effect typically also exhibit the disposition effect.
Investors tend to feel comfortable investing in stocks locally. This can be from companies headquartered in their hometown, companies within their state or the investor’s employer. This home bias investing can lead to financial disaster, especially if the investor’s employer faces financial trouble later.
What You Can Do to Make Better Decisions
If you recognize the above behaviors, you have a better chance of making financial decisions that could lead to profits. If you can remove the emotional factor from your investment decisions and access your analytical mind, then you can look at the stocks objectively.
Being constantly bombarded by negativity concerning certain stocks will keep your mind focused on the market and activate the disposition effect. Try to tune out the markets by only checking on brokerage accounts every few days, once a week or less. If you must check more often, change your settings to hide your gains and losses as well as purchase prices.
When you worry about highly-publicized news stories concerning the stock market, not only do you fall into psychological shortcomings, but you may fall for scams from unscrupulous promoters who prey on the investor’s psychological state. These scams sound legitimate because your emotional state has taken control.
If you do watch news media regarding stocks, take note whether the hosts are expressing their opinion. Biased shows giving one person’s opinion may affect your trading if it is the only opinion you hear. Before making a financial decision, analyze your belief behind the transaction.
Remember that, to the average investor, a trade is not going to make or break you. Remove the emotion, and trick your brain into allowing you to achieve your financial goals.