Personal Finance

This impulse makes investors sell low and buy high

Here's why investors make mistakes

Feeling nervous about your portfolio today?

Classic Wall Street advice dictates that good investors should know when to cut losses short. And certainly, some folks get lucky and manage to time trades perfectly so as to sidestep big market drops.

But most of us are bad at market timing, and the consequence of selling stocks as they start to dip tends to be locking in losses rather than avoiding them. It's hard to see a market bottom — and the best moment to get back in — until after it has already passed. In fact, the very impulse to protect yourself, called "loss aversion," may be predictive of investment errors, a new study suggests.

People who are especially emotional and loss averse are more likely to make the mistake of needlessly selling holdings and switching to cash in a down market, said University of Missouri professor Rui Yao, co-author on the paper.

"If you were laid off and don't have an emergency fund, that's one thing," she said. "But these are people who don't have immediate consumption needs and aren't harvesting losses for tax reasons. They shouldn't be moving into cash."

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As a proxy for loss aversion, Yao focused on people who said they expected to work during retirement and travel less following the Great Recession. These respondents tended to be more unhappy than others in reaction to the downturn and were about 1.5 times more likely to switch to cash when they didn't need to.

Human nature might be part of the problem, as emotion tends to trump reason for many investors: Research has found that the average person is willing to risk a potential loss only if he or she stands to gain at least double that amount.

For investors who are especially loss averse, the financial consequences of an emotional reaction can be serious, said Yao.

For example, dumping most of your investments during the October 2014 correction would have lost you more than 15 percentage points in annualized returns compared with a person who held on and stayed invested.

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A separate Brigham Young University study has found that emotionally driven financial fallacies can go hand in hand, said co-author and BYU psychology professor Harold Miller. Miller's research showed that people who demonstrate loss aversion are more likely to fall victim to the sunk-cost fallacy, and vice versa.

"The sunk-cost fallacy is behaving as if more investment alters your odds," he said. "In a way, you are also motivated by an aversion to loss, but you keeping investing more, believing the more you put in, the more it will pay off."

In essence, the same people who flee from risk at the wrong moments are more likely to double down on risk irrationally.

But fearfulness is not the only threat to investors' portfolios. Yao's study also examined other traits that predict the mistake of moving to cash without a need to do so during a downturn, such as confidence and gender.

While slightly less than 10 percent of women made the error, more than 12 percent of men did so. Investors who demonstrated higher-than-average confidence — stating they had greater confidence about their financial future in 2008 than they did in 2003 — were also more likely to make the mistake.

"These confident people seemed to think they could get out of the market and just get back in later," Yao said.

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Yao's findings were based on data from a Financial Planning Association/Ameriprise survey that examined the characteristics and behaviors of more than 3,000 U.S. residents during the Great Recession. Overall, about 1 in 10 of all people surveyed made the mistake of moving to cash without a consumption need.

If emotion is a major factor that drives investors to "sell low," it can also explain why people "buy high." A different study Yao recently co-authored found that households who just experienced investment gains are twice as likely as others to invest all of their workplace retirement portfolio in stocks.

Investing based on emotion has consequences: Over the last three decades, U.S. stock investors have lagged the S&P 500 by more than 7 percentage points annually. Instead of holding on to earn market returns, investors shortchange themselves by trading in and out — at exactly the wrong times.

So if you have a diversified portfolio, an investment strategy and an emergency fund in place, the best move you can make in a rocky market might be none at all.