Everyone knows that the best way to make money in the stock market is to “buy low and sell high.” Yet the individual investor seems to struggle with this basic tenet of investing. Decades of research indicate that in aggregate individual investors tend to “buy high and sell low.” This pattern proves consistent whether investors buy individual stocks or mutual funds.
New studies in behavioral science and the new field of neuroeconomics shed some light on this phenomenon. As a person contemplates the future and puts together a financial plan, he or she uses the prefrontal cortex of the brain. This is the part of the brain that controls rational thought, personality expression, decision making and orchestration of thoughts and actions in line with internal goals. Once the plan is created, the individual begins investing in assets which, according to the plan, are likely to help the individual achieve the long-term financial goals.
When this investor begins to lose money (investing in stock requires the investor to weather bear markets, sizeable corrections, and once a generation a “crash”), he or she experiences a natural decline in cognitive ability and another part of the brain begins to control investment decisions. The more primitive hypothalamus is the part of the brain that deals with stress and the primal “fight or flight” instinct. We an investor begins to lose money, emotions take over and the well-thought-out, long-term financial plan is replaced by an instinctive need to “do something.” Left to deal with these emotions all alone, the investor often will buy and sell at the wrong times.
Given that our brains may be wired in such a way to hurt of our ability to invest on our own, what can be done? Studies have shown that retires who have private health insurance are less likely to “freak out” in a market declines that those who do not. Another way to reduce the anxiety of bear market or correction is to talk to someone else. In those times with an investor may be thinking emotionally, another person (who is not losing money) may be able to assess the situation more rationally, and provide perspective, clear-headed advice and solace. This is one of the benefits of using an investment advisor to help make financial decisions. One recent study indicated that investors with a written financial plan and who use an advisor were 50% more likely to maintain their target asset allocation than those investors who go it alone.
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