Dear Irrational (do we fall in love with our investments?)
Dear Irrational,
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?
——-
Dear Investor,
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.
Irrationally yours
Dan
Dear Irrational,
It would be great if you changed your RSS feed from partial to full. Makes it A LOT easier for those of us using feedreaders.
I think that Jim Cramer called this a “cult stock” once. Perhaps I am wrong in attributing the term to Cramer, though I have heard the term used in reference to Apple’s stock – which is known to see rapid increases and decreases in it’s price – without much rational expectation of greater future earnings.
The “cult stock” seems to maybe be the brokers’ way of talking about the endowment effect among certain stocks? Perhaps this has more to do with the love that many consumers have for Apple’s products, a love that perhaps accounts for folks buying and holding the stock that might not otherwise be participating in financial markets.
Just a thought…
I also have a background in the financial industry. Brokers and clients commonly fall in love with their investments. In the current environment we need to stress to our clients that the market has natural cycles. Most forget the market has corrections all the time. Remember 2001-2002? At this moment, the market has “gone on sale.” Now is the time to be buying not selling. I suspect most clients who got hurt were borrowing on their paper earnings or treating it as if was cash out of their pocket. Show them the total they have put into the market and how much it is worth now. Don’t focus on the paper loss focus on the overall paper gain. And remind them, it isn’t a Real gain until they have the CASH. The rest of the time it is rolling around in that biggest casino on earth, the market. They were gambling and if they made risky choices, as many did, they gambled and lost. Stocks are by definition one of our riskiest gambles. That’s my 2 cents on the subject.
I think people fall in love with their holdings, period. There are many stockholders who feel that this is not a good time to buy stocks. But if they were rational, shouldn’t they then sell all of the stocks they hold?