Emotional investing

I have some good friends who like to tell me all about their most recent hot stock picks. You surely know the type. They always have some winner and they enjoy talking about how smart they were in buying that stock. The real question is, were they truly that smart, or did they just get lucky?

When I ask these friends what type of technical analysis they did on their stocks, they'll start talking about P/E ratios and the usual indicators, but then they'll say "but I just had this hunch!"

When pressed about whether all stocks in their portfolios have outperformed the market, they always become more down-to-earth. "Sure, we've picked a couple of dogs. Who hasn't?" When I ask their overall return, most don't really know, but they feel good because they had that one winner in there. Why is it that perfectly rational people can become so irrational when it comes to investing their money?

This brings me to the point of this article, which is the psychology of investing during a bull market. My friends are the perfect example of investors who allow a bull market (and a rather lengthy one at that) to begin to cloud their judgment.

Signs of Overconfidence

Investors having success on the market may develop a sense of overconfidence. They begin to interpret accidental success as being a product of having somehow miraculously acquired superior investment skills. Just the fact that one or two stocks, on which they had a "hunch," are up big is enough for them to think they're now investment experts. This is the first step on the road to turning investing into speculation.

This overconfidence has recently been portrayed by many investors. They start to think that the highly improbable becomes impossible, or that the highly probable becomes guaranteed. Ask anyone how they would react to the possibility of their stock portfolio going down approximately 38% over two years and they'll look perplexed, as though thinking "how could that happen?" Then ask them to think back to the early 1970s, when the S&P 500 Index declined 14.7% and 26.5% in 1973 and 1974, respectively. Think it can't happen again? Then you've just decided that the highly improbable is now impossible.

Most investors, if they truly thought about it, just wouldn't feel comfortable exposing their entire portfolios to that kind of risk. Yet when you look at how infrequently investors rebalance their portfolio asset allocations, or how many times investors have a large position in just one or two investments, by default they have fallen victim to the psychology of investing. They begin to believe that the market can only go up, asset class diversification just doesn't work anymore, and they somehow have become smarter than the market, i.e., they know which stocks the market has misjudged and, therefore, underpriced. When individual investors start to think they know more than the collective market does, that's a dangerous situation.

High Risk Pitfalls

Certainly there are times when not having rebalanced a portfolio or holding onto a large position in a small number of stocks has paid handsome rewards to an investor. Investors need to remember, however, that with the potential for greater returns comes the potential for higher risk. And when an individual investor allows their asset allocation to become overweighted in high performance stocks, or they don't diversify, they've guaranteed that their portfolio now contains greater Levels of market risk.

Another psychological trap investors may fall into is buying or holding onto an investment because they've somehow become emotionally tied to the investment. An investor may inherit a portfolio or may continue to hold onto an investment, even after it no longer meets the investor's needs, because it's a "favorite." There are certainly tax implications that come into play when looking at whether you should consider liquidating some or all of an investment in your portfolio. But keeping certain investments (which usually skew an individual's asset allocation and risk tolerance) purely for emotional reasons just doesn't make any sense.

Smart Investing

Believe it or not, I'm not trying to take all the fun out of investing. But eliminating emotion and managing risk (through asset allocation and asset class diversification) in an investment portfolio are two important concepts that should never be overlooked or, heaven forbid, forgotten.

Make sure you don't let irrational beliefs about investments or markets permeate your thinking about how you invest. Don't become overconfident based on recent performance. Create a personal investment policy statement that details the level of risk you're willing to assume and the returns you expect. Structure your portfolio to allow you to achieve the returns you seek at the level of risk with which you are comfortable.

And if you like the fact that your portfolio has performed well over the past few years, or a certain stock has grown to be a larger percentage of your portfolio, fine. Just make sure you understand the risks inherent in keeping your portfolio in its current state. But you should be aware of what a worst case scenario might do to your portfolio over a short time frame and make sure you're willing to stick with it should the inevitable downturn happen.

Finally, if you need help understanding the risk of your portfolio, look to a professional who understands your needs and objectives, helps you monitor your portfolio returns vs. your financial objectives, and helps you tailor a strategy that will achieve your goals through both bull and bear markets using modern portfolio theory and discipline, not hope and emotion. planning and investment advisory services. He has more than 10 years offinancial services experience and is a faculty member at the Schools of Banking, based in Lincoln, Nebraska. This article first appeared in the September/October 1999 issue of Ideas for your Success, a publication of RSM McGladrey, Inc., Business Solutions.