Stocks Too High? Emotions Will Cost You

Posted on March 6, 2015 at 11:51 AM PDT by

You might recently have seen headlines about the NASDAQ. The tech-centric stock market has broken through its previous all-time high, set back in the dot-com days.

It soon fell right back under the record, of course, but it is likely to advance more than retreat over the coming weeks, and the headlines will fade. The same thing happened with the Dow and the S&P 500 not long ago.

We pay a lot of attention to false positives in the financial media, events that supposedly prove that assets are overvalued or undervalued. It can be very easy to forget that behind all the certainty of the news headlines is 100% conjecture — plain old guessing.

stocks too high

Yes, if enough people pile on during up years, stocks can correct lower. It’s just human behavior to want more of a good thing.

But it’s also human behavior to fear losses, what behavioral science researchers call “loss aversion.” They do complex psychological experiments to test these ideas, but the bottom line is easy to understand: We make irrational, costly choices when presented with the risk of losing money.

So fundamental is that urge that some studies show that our fear of losing money is twice as strong as our desire to make it. The result often shows up as selling perfectly good investments on the mere hint that something might go wrong.

We feel better staying out, and we discount the obvious and concurrent risk: That markets could instead go up — as they did in 2013, for instance — and you miss the gains by sitting on the sidelines in cash.

Staying invested is a big deal. The only way to compound your money is to realize gains and to reinvest those gains.

For most investors, that means steadily reinvesting dividends and gains made from rebalancing, that is, from programmatically selling off some of the “winners” in a portfolio and dedicating those gains to the relative “losers” in the same portfolio.

Stocks too high fix

Rebalancing tests your loss-aversion brain circuitry in a major way. You are being asked to get rid of a portion of a stock that has treated you well and to give those resources to a stock or other investment that has not — at least on paper.

Take a step back. By rebalancing, what you’re really doing is selling high and buying low. Ask any 10-year-old how to make money and the logical conclusion will come back to you as “buy low and sell high.” Rebalancing flips the order, but it’s the same transaction.

If you truly fear a major market meltdown is in the near future, well, that’s a sign that you are invested in ways that are too risky for your own mental well-being. The solution there is to revamp your portfolio to have a more conservative tilt.

That move alone will change your life in terms of your relationship with money. You’ll sleep better for sure. Playing chicken with the markets will change your life too, but not in the way you would hope.