3 Emotions That Will Destroy Your Retirement

Posted on October 19, 2010 at 3:36 PM PDT by

While many retirement investors have felt tempted to flip Wall Street the middle finger in recent years, famous Italian artist Maurizio Cattelan took this impulse to a new level. In a highly publicized event, Cattelan created a bold sculpture called L.O.V.E., an 11-meter tall marble middle finger that has been strategically placed at the entrance to the Milan Stock Exchange by the city council of this fashionable Italian city.

Intended or not, the controversial modern artist has successfully tapped into a deep reservoir of investor sentiment. His sculpture, though criticized by stock exchange representatives, has been met with public praise. While it remains a mystery as to what L.O.V.E. exactly stands for, it is clear that when it comes to investing, many investors aren’t feeling the love.

As good as it may feel to flip the finance industry the finger, it provides little salve for a damaged retirement portfolio. Additionally, researchers have demonstrated that bringing emotions into portfolio management is directly linked to poor returns. In fact, the burgeoning field of behavioral finance has demonstrated several areas where investors would do well to control their emotions.

Three of the most significant emotional landmines identified by behavioral finance experts are recency, loss aversion, and overconfidence:

The recency problem: Recency is the psychological tendency to overweight the recent past when reviewing historical information. The investment effect can be devastating. Apple or Google have been hot in recent months, so investors pile in. Sure, everyone remembers the collapse of the tech bubble in 2002, but this time is different, or so the deluded investor thinks.

Rejecting recency: The way to overcome recency is to follow the example of an institutional investor whose methodology is informed by deep and long-reaching historical time frames. The result is a portfolio built around very specific asset allocation goals. By defining your target allocation and committing to that focus, you can overcome the psychological impulse to follow the latest fad.

The loss aversion problem: Behavioral finance experts have revealed that investors feel twice the pain from loss as they do the pleasure of gain. When an investor’s portfolio grows by 30 percent in a year, he definitely feels good. But when that same investor’s portfolio dropped by 30 percent in 2007, he likely felt that his financial world had come to an end.

Losing your loss aversion: By acknowledging the physiological influence of loss aversion, you can begin to tame this emotional beast. Begin by taking your defined asset allocation and committing to disciplined rebalancing. When an asset class is running to the moon, a firm commitment to rebalancing will help you capture gains and prepare for future market shifts, which the science of investing suggests will surely come.

The problem of overconfidence: Another discovery is that each human has an innate tendency to subtly believe that they can outwit the markets. This Superman effect can lead investors to believe that they can leap normal investment returns in a single bound. The result is overtrading, getting married to a single security, or abandoning a pre-defined allocation. Worse yet, some investors who act on overconfidence will experience short-lived success deepening their faith in their own ability. Unfortunately, a small fraction of investors can sustain these superpowers for any length of time and sooner or later end up crashing to the earth as the kryptonite of highly efficient markets win the day.

Overcoming overconfidence: A great elixir for overconfidence is a good dose of historical reality. Add to your investing an ongoing commitment to reviewing the history of equity markets. Draw upon examples of equities and sectors that were at one moment highly celebrated but then quickly turned awry. In 1999, Enron was universally praised as an energy giant. One year later, it was toast. History is replete with examples where investors could not see the cliff around the next turn.

Instead of giving Wall Street the middle finger, embrace a disciplined approach to your retirement investing. Be aware of subliminal power of recency, loss aversion, and overconfidence. By committing to a clear asset allocation and disciplined rebalancing you will outwit your emotions and feel the investment love that seems to be escaping many.