By: Cedric Mbanga
Breaking News: “You cannot work forever. You have to retire sometime”.
As you plan for retirement and decide to become an active participant in financial markets, you can be full of hope. Hope that you can accumulate enough wealth to be able to maintain your current lifestyle during retirement.
You can also be full of fear — fear of losing all of your investment. So which one are you? The hopeful? The fearful? Or is there a middle ground?
Finance professionals see fear as an emotion consistent with the observation and expectation of continual poor performance of an investment. While this emotion is not unusual in financial markets, our response to fear can have important implications for our investment’s value.
Many of us would expect that with anticipated negative performance, any investor would immediately sell off the asset for which the value is expected to decrease. This intuition, however, has historically proven not to apply to the average investor.
We tend to hold onto losing assets too long, demonstrating a clear preference for paper loss rather than realized loss. It is not until we realize the loss that it “hurts” and we are willing to delay this pain for as long as we can. Yet, this attitude unsurprisingly leads to further negative returns.
So why do we wait so long? The answer is hope. As fearful as we are, we are also hopeful. When facing uncertainty and experiencing negative returns, it is hope that gets us to ride our losses even further. Perhaps even more interesting is the average investor’s attitude when experiencing positive returns.
You would think the common of us would hold onto, for as long as possible, an asset for which the value has increased over time. Well, historically, investors have gotten rid of — sold off — those assets too soon, demonstrating in this case, a preference for realized gains rather than paper gains.
The average investor behavior described above is known among finance professionals as the Disposition Effect. It somewhat characterizes our risk loving behavior with respect to losses, and our risk-averse attitude toward gains.
What this suggests is the importance of understanding how hopeful we are when experiencing losses, and how fearful we get when experiencing gains. It also tells us that we are neither consistently hopeful, nor are we consistently fearful.
Although we tend to choose what we depend on based on our most recent experiences, we are also likely to overreact to recent positive returns, and be greedy; or underreact to negative returns and act as ostriches — putting our heads in the sand.
Greed, in financial markets, can be disguised as hope. So, perhaps there exists a middle ground that financial market participants ought to identify.
Warren Buffet famously said: “Be fearful when others are greedy and greedy when others are fearful.” So, which are you — fearful, hopeful or greedy? No matter which you are, it is important to be attentive at all times.
Dr. Cedric Mbanga is an Assistant Professor of Finance at Missouri State University. Part of his research focuses on behavioral finance. Statements in this column are intended for educational and informational use only and are not to be construed as investment advice.
This article appeared in the July 1, 2017 edition of the News-Leader and can be accessed online here.