I am a partner in an asset management company whose purpose is to manage investments for individuals, families, and foundations. The principles of Predictably Irrational made me think about the effectiveness of each component in our investment process. My end in mind is: 1) to identify failure ingredients in my investment process and 2) engineer out their removal.
My question follows:
Is ‘falling in love’ with an investment hazardous to one’s financial health? Does ‘falling in love’ with an investment result in predictable behaviors (in me) that lower (or negate) what would otherwise have been an excellent investment performance?
We have not done any research directly on this question. Nevertheless, I suspect that the answer is that we do get attached to investments, that it is not good for us, and that it has the potential to influence our judgment for the worse.
First, regarding ‘falling in love’ with an investment; I think that we would. What we know about the endowment (ownership) effect is that people tend to fall in love with anything they happen to own (mugs, pens, cars, kids). Once we have something, it becomes ours and we perceive it as special. As a consequence, we value it more. I suspect that the same could occur with investments.
On top of that, in the current economy people are feeling like they are in a losing situation (if you don’t feel this way look at your retirement account) but losses in the stock market are not psychologically realized until they are truly realized. So in people’s desire to hold on to what they have you might suspect that in this economy there is going to be an even stronger tendency to ‘fall in love’ with an investment.
Why is this not good for us? Because the expected value of investment options are about their future potential and the past is just water under the bridge.
The good news is that you can do something about it, and advise your clients to do the same. Imagine that at the start of every month you don’t look at your portfolio and instead you design your strategy and market positions as if you started from scratch. The idea is that if you start from scratch you have a clean past with no commitments to past decisions. I am not sure if the ‘falling in love’ with an investment sentiment will go away completely but I think this way it will be less powerful.