The Psychology of Investing: How We Cope With Risk

Researchers have found investors have a tendency to psychologically exaggerate declines in the performance of an investment and to minimize gains. It’s a phenomenon with a complex sounding name — “myopic loss aversion” — but one that makes a simple point: Psychology plays a role in our investment decisions. Understanding that role may help you stay on course toward your long-term financial objectives.

Framing Expectations of Investment Performance

Individuals subconsciously “frame” expectations based upon how the information is presented to them. For instance, would you prefer to invest in a security that has a 40% chance of yielding negative returns or one that has a 60% chance of yielding positive returns? Many people would choose the latter, even though the same investment opportunity was offered in both cases.

Choosing “Safe Bet” Investments

It’s human nature to want to choose investments that have performed well. On the other hand, many of us are naturally risk-averse. Sometimes these inclinations combine to make us less effective investors. For instance, do you know people who wait to invest until they hear of a security that consistently produces above-average returns? Then, sensing a “safe bet,” they purchase this investment — often when it’s at peak value. If the investment drops in value, they move their money to what they perceive as a less risky security or even pull out of the market altogether – even if such a move clashes with their long-term goals.

This sort of short-term thinking creates risk, too. When investors move in and out of the market, they’re practicing an investment tactic known as market timing. The risk is they’ll misjudge the market and lose out on potential gains. Even professional portfolio managers admit it can be difficult to predict market changes.

How Personal Experience Affects and Our Investment Portfolios

Research has shown individuals who grew up during the Great Depression are more likely to invest conservatively, while those who entered the market during the mid-1990s expect high returns and tend to invest more aggressively. Being aware of how past experience may influence your perceptions can help you avoid financial strategies that may work against you.

So What Can You Do?

Several strategies may help you minimize the role emotions and psychological tendencies play in your investment decisions. Stay focused on your long-term goals and not the market’s short-term moves. Develop – and stick to – a well-thought-out plan that’s based on your goals and your personal tolerance for risk. And rather than reviewing your investments’ performance every week, consider scheduling quarterly or semiannual portfolio reviews with your financial advisor.

To schedule a review of the performance of your investment portfolio, contact a Fifth Third Bank financial advisor.

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