I love to make fun of economists and engineers, who get really mad when you point how humans act irrationally and how their “models” are therefore wildly off-base because they never deign to talk to psychologists in all their infinite wisdom. In fact, here are some of my favorite links on investor psychology and psychology book recommendations.
To show you what I mean, here’s another thought-provoking guest post from Carl Richards at behaviorgap.com.
Carl Richards: 5 things to ask your friends who think “this time is different”
“Given the decade we just finished, the question about what to do now is becoming part of our national conversation. With the insane amount of noise in the press, here are a few things to think about.
First some assumptions:
- Your long-term investments are super diversified and low cost (broad-base, index funds, for example).
- You are only investing money in stocks (see #1); that is long-term.
- You have a plan for meeting short-term needs.
With that out of the way, here are a few things to think about:
- The Sunk Cost Fallacy: We all have a tendency to look at the money we have already lost and think that we need to sell because we have lost so much. How much we are down has nothing to do with what the best decision is NOW. What is important is that we focus on making the best decision now, looking forward.
- Anchoring: We are wired to take the recent past, anchor to it, and project it into the future. You start to do calculations like, “If the next decade is like the last I would be better off putting my money under my mattress.” We do this when times are good (in late 1999, eight out of every 10 dollars invested went into tech funds, right after a 80% run), and now we are doing it in bad times. Do we really think that this is the end? Are we really never going to solve these problems? Should we all move to the hills to grow our own vegetables? This is one whopper of a cycle, BUT IT IS STILL A CYCLE.
- Why are stocks the only things that Americans buy when they are marked up and sell when they are on sale? If you thought stocks were a good investment in 2006 and 2007 (and we all did), then wouldn’t they be even better when they are a lot cheaper?
- The question of the day is do you think that stocks will outperform cash and bonds for the next 10 years? The U.S. government is offering to pay 3% on a 10-year treasury. After taxes and inflation that will cost you money to own. Do we really think that if you bought a broadly diversified portfolio of stock mutual funds and then committed to completely ignore it for 10 years (not 10 days or 10 months) you would be better off sitting in a CD?
- What we are talking about is expected future returns. The fact that we just had one of the worse decades ever, means that expected future returns went up, not down.
Just a few things to think about as you make changes to your 401(k) or your investment plans. It is scary out there right now, but it seems irrational to assume that this will be the first time ever that a bear market never ended.”
Check out more about investor psychology at Carl’s blog behaviorgap.com.