I recently read an article by Morgan Housel about the detrimental effect emotions and memories have on investing behavior (you can read it here). Not surprisingly, people tend to recall bad memories more easily than good ones, and seek to avoid experiencing those emotions again. When such behavior interferes with investing, you get something called loss aversion. Housel explains it like this:
“The market falls 50% in 2008 and early 2009. That hurts. Then it rallies 130% over the next few years, recouping all of your losses and then some. This feels OK, but not nearly good enough to ease the shock you felt from the 50% crash, which was emotional and memorable. You remember the crash much more vividly than the ensuing rally, and you change your portfolio to make sure you never suffer through a crash again. You buy bonds, hold a lot of cash, and swear off stocks for good. We’ve seen quite a bit of this behavior over the last few years. And we know it comes at the expense of long-term performance.”
A study conducted on people whose brains suppress emotion (due to the presence of a lesion on the brain) found that they did not suffer from loss aversion, and were able to make rational decisions that resulted in a higher payoff. One of the study’s authors referred to these people as “functional psychopaths” since their choices were unaffected by emotions (personally, I think “Vulcan” would have been a bit less insulting, but perhaps this guy is the only scientist on the planet unfamiliar with Star Trek).
In addition, “our memories of emotional experiences tend to get rearranged and distorted, so much so that some of what we remember never actually occurred.” (I think the author must be acquainted with some of my extended family members – I am all too familiar with this phenomenon.) So what is an investor to do? Housel provides the same advice as that given to dieters – keep a journal. It’s easy to say you’ll be a rational investor (or a healthy eater) but far more difficult in practice. The best way to remain accountable is to keep an accurate history, refer to it, and learn from it.
Live long and prosper.
Sarah DerGarabedian, CFA