Monday, December 1, 2008

Stocks Cause Psychological Pain

How bad have stocks been lately? Regardless of what the numbers say, what matters to people is how they feel about stocks. Two people can feel very differently about the same events. Here we have a couple disagreeing about stocks:

Sue: “After all this excitement in the stock market, the last two weeks have been good.”

Andy: “Are you nuts? Stocks have been brutal lately. Worrying about our savings is keeping me awake at night.”

Sue: “But I’m talking about just the last two weeks. Look at this chart.”

Andy: “That proves my point. The TSX went down below 8000. At this rate, we’ll never be able to retire.”

Sue: “But we’re up 2.4% in these two weeks. That’s good for such a short period of time.”

Andy’s reaction is more typical than Sue’s. The pink region in the chart measures Andy’s psychological pain of watching stock prices sit well below where he hoped they would be. It’s like watching your favourite sports team when they’re way down. Even if they close the gap somewhat, fans suffer psychologically while their team trails badly.

Andy isn’t wrong. After all, he knows his own feelings. But, the way he perceives the stock market may cause him to make choices that hurt his long-term returns, such as selling at a low point. The truth is that the past two weeks have been good for investors’ returns (as long as they didn’t sell), even if it made many of them ill.

Sue’s temperament is better suited to investing success. She ignores the pattern of prices during a period where she didn’t trade stocks. In a month, she won’t care what prices are like today.

Although individual stocks can fall to zero permanently, you’ll have much bigger things to worry about than money if the entire stock market goes to zero. Sue remained calm and trusted that stock prices would rebound eventually. Stocks may drop again in the short term, but it won’t be permanent.


  1. Nice thoughts. You start to undertand how much psychology matters when you invest through a period like this. It is easy to talk about the psychology of investing when things are relatively good and stable. The last 3 months have probably really separated a lot of the wheat from the chaff.

  2. Except Sue's still thinking short-term. The argument can easily be turned around if Andy simply says "but the last 2 months have been brutal."

    Even then, Andy's short-term. If they're investing for the long-term, then 2 weeks, 2 months, or even a year shouldn't really concern them too much outside of looking for good spots to add to their portfolio, be it for cost-averaging or just finding value.

    To keep the sports analogy - it's like saying "Hey, our team is on a 3 game winning streak!" Even though they're 3-15. But if they're doing terribly because the team is rebuilding, you look into the future and look for the areas that show promise in today's numbers.

  3. MG: You're right about the difficulty of handling a period like this. It's like the quote attributed to Mike Tyson, "everybody has a plan until they get punched in the face." Hopefully, those who come through without giving up will handle the next market drop more calmly.

    Astin: When we say that an investor is "thinking short-term" we mean that they make investing decisions based on the recent past or about expectations for the near future. Just making an observation about the recent past is different from making short-term investing decisions. The point of my little dialog was to illustrate how these two hypothetical people perceive this particular two-week period. The person who sees it as Sue does is more likely to remain calm and maintain a long-term view. Andy is more apt to panic and make a short-term decision to sell when prices are very low.

  4. Michael,

    Love your blog, but I must disagree.

    Sue is ill-suited to being an investor. All she knows is the unlimited risk associated with owning investments. True, most people adopt this methodology, but that does not make it an intelligent thing to do.

    Sure, the recent period has been 'good' but her net worth has been decimated, and she is willing to ignore that.

    By burying her head in the sand and assuming all will be well at some unspecified future date, her main strategy is 'hope.'

    Hope is not a viable investment strategy. I'm a big fan of protecting investment portfolios with options.

    Best regards,

  5. Mark: Glad to hear you like my blog. Your comments apply equally well to me because I don't use options to protect my portfolio.

  6. It's a real head scratcher. Is it better to think of the last 2 weeks or the last 3 days? Both are brutally short term. I guess it is more advantageous to be long-term optimistic and calm. Mark's comment is interesting, but I don't know what (if any) action to take to mitigate my risk.

    I find the good ol' Mr Market analogy handy. Don't let him influence you, just take advantage of him when his quote is too low or too high. This definitely requires a stronger opinion on an individual company's value than the more typical "Where is the market headed?"

  7. Gene: I tend to think about a lot of things. So, I might think about both a 3-day period and a 2-week period as well as other longer periods of time. I chose 2 weeks because it was handy for the point I wanted to make with my little dialog, not because 2 weeks is somehow an important duration.

    I always liked the Mr. Market analogy, but mispricings have to be extreme before I feel confident that I am right and Mr. Market is wrong. I am betting right now that Mr. Market is undervaluing stocks across the board, but not a big gamble. For example, I'm not using leverage.