Don't Let Emotions Drive Your Portfolio

One thing that separates humans from robots is our capacity to feel — and our ability to throw away absurd sums of money on dud investments.

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We mean well — most of us think we're making smart decisions when we invest in a stock, mutual fund, or even a house, but our reasoning is often clouded by personal or emotional experiences that can delude us into believing the most preposterous of notions. Worse yet, we aren't even aware of the influence emotions have on our decisions.

"I think the best investment strategy is to pick some stocks or mutual funds you like, and stick your head in the sand and protect yourself from emotions that are going to cause you to do stupid things," said George Loewenstein, a professor at Carnegie Mellon University.

Loewenstein collaborated on a study last year that found that people who had suffered brain damage made better financial decisions than those who hadn't. The study compared normal people to those with neurological diseases that impaired emotional responses. Participants in the study were given $20 to invest, and in each round they could either invest $1, or they could refrain from investing, in which case they got to pocket the dollar.

After roughly 20 investment rounds, the study found that emotionally impaired participants invested more often — they invested in an average of 83.7 percent of the rounds, while emotionally normal participants only invested in 57.6 percent of the rounds. The emotionally impaired group earned more, too: They made an average of $25.70, while normal participants earned $22.80.

"People with emotional lesions invested at a very high rate, while normal people, if they lost money, they got discouraged. If they won a few times, they got nervous that their luck wasn't going to hold out," Loewenstein says.

How do we let emotions get in the way of our investments in real life? It happens all the time, according to Gregg Fisher, president and founder of investment advisory firm Gerstein Fisher. Off the bat, Fisher says, we tend to hold on to high-return, winning investments longer than we should, and we're reluctant to sell losers until we've won our money back, even if that's an unlikely outcome.

"People tend to hold on to things even if they're no longer favorable investments. ... People put more value on things they already have," Fisher said. "Many people have held things for many years, and they're afraid of change. But I ask my clients if they came in with cash, would they buy back the same position? Usually their answer is 'no."'

Likewise, Fisher says, people often have wildly optimistic ideas about what kind of returns they'll get on investments.

"Maybe someone buys shares of Google (GOOG) at $100, and the stock goes to $400, so he has a good experience with it and he wants to buy more — but buying shares at $400 may not be the best way to invest. People have a positive experience, and they take it and extrapolate into the future — it's a mistake," Fisher says.

It's just one of many goofs we make. Kay Shirley, an Atlanta-based author and financial adviser said many of her clients' portfolios have been destroyed by pride.

"There's this 'I'm different' feeling," Shirley says. "People see mistakes others have made, and they think they're immune or it's not going to happen to them. I advise my clients to, when they're considering an investment, double your emphasis on the negative and half your interest on the positive, and see if your judgment would be the same."

Another common error, according to Fisher, is our fixation with the familiar. We're less likely to invest in a company or mutual fund if we don't have a direct or positive feeling about it.

"It's the difference between Wal-Mart (WMT) and Sears (SHLD). You hear all this exciting news about Wal-Mart, while Sears, you might just think of it as an old catalog company. It's less familiar and less exciting. Investors tend to favor the things we're all positive about, so the price of Wal-Mart goes up because of all these positive feelings. But you could also have a great company, like Sears, at a bad price," Fisher says.

Shirley says she often sees clients invest in startup companies because they know someone who works there, and because they have access to information about the company, and believe "inside" information is better than publicly available information.

"Sometimes clients get 'hot tips' — generally they're from a friend or child working at a startup — and clients think that whatever they hear is really going to happen. Sometimes they do, and even if clients buy shares at the right time, they don't sell, and they ride the stock down," Shirley says.

Moreover, buying on inside information can be illegal.

One of the most practical pieces of advice, say experts, is not to lose sight of the big picture.

"We tend to compartmentalize our portfolios — we have safe money, risk money, bond money — but on the whole, the portfolio may be highly inefficient," Fisher says. "People like to buy more of what went up and less of what went down, but you need to have the big picture. Portfolios are like good dinners: You don't want to order the wine until you know what the meal is."

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