Gil’s Musings

The Psychology of Investing

The psychology of investing is a life’s work, worthy of its own PhD program. We all have demons in our minds, and taming the demons can be hard, but is a worthy cause. Those demons can cause us innumerable sleepless nights, and for the most part, self-damaging responses. In many ways, we are our own worst enemy.

One of the leading psychologists on the investor’s mindset is a man named Daniel Kahneman. He won the Nobel Prize in Economics in 2002. Human irrationality is his life’s work and the theme of his theories. He has written many books on the topic, but one of his more important achievements revolves around his findings about how we experience the emotion of financial loss and gain. He concluded that people experience the emotion of a loss three times more acutely than the pleasure of an equal gain. So if I were to ask if your $10,000 and my $10,000 were of equal value you would probably say yes. Yet, my response would be that it depends on who had it first. From an emotional standpoint, my $10,000 is really only worth $3,000 if you are taking it from me. But your $10,000 is worth $30,000 if I’m taking it from you; at least in your mind. This gives investors an emotional stake of ten to one in seeking to avoid loss as opposed to seeking gain, with the same money at stake. Humans were also never designed as battle beings. We are too smart. We tend to run, hide, or climb a tree.

Segment Wealth Management People experience financial loss.JPG

Clearly this has profound implications for investment “policy” for the typical investor. Mike Tyson once said, “Everybody has a plan, until he gets punched in the mouth”. The ability to stand there and trade punches is not for the faint of heart; but frankly, tends to work out better for investors than standing in the corner with your gloves on your face. What I mean by that is the market has a remarkable history of getting winded and is probably unable to knock you out. Staying diversified is the key to longevity for investors, because mental demons will remind you of the Enrons of the world at precisely the wrong time. Betting on thousands of companies in a fund or portfolio approach, or owning bonds as a way to avoid stock risk entirely are keys to keeping your sanity when the punches are raining in on you. It is our safest way of hiding.

We all have vivid memories of the 50% or larger losses in stocks in 2001 and 2008. We simply have less vivid memories of the subsequent recoveries. Part of this is due to the traditional process of notching gains in small and orderly steps as opposed to the violence of declines. Essentially, we climb stairs one at a time, and we fall down stairs five at a time. This reinforces our mismatched gain/loss “rationale”.

I’ve been an investor and advisor for thirty-two years and I have my own demons. As you ponder how this applies to your life story of investing, you may have learned how to conquer the demons of your own making. If not, then you probably understand the work you have yet to do.

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