Why Emotional Investors Are Hardwired for Failure

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While one of the most common investing problems we hear about is "buying high and selling low," there is also evidence that investors tend to hang onto bad investments for far too long. Some investors even take on more risk when they're underperforming, effectively doubling-down on losing bets or taking on new risks in response to a bad run. 

Why do we do this -- and more importantly, what can we do about it? 

Where it all begins: A look at Australian flood victims 
This a difficult issue to study because it requires some kind of significant loss beforehand, which is hard to replicate in a lab environment and unethical to construct in the real world. However, every now and again a "natural experiment" arises that mimics, in large part, the structure of an experimental study. 

In 2011, the Queensland province of Australia experienced massive flooding that caused billions of dollars in damages and affected over 200,000 people. The capital city, Brisbane, was heavily hit. Whole neighborhoods were flooded, and in some cases, houses on one side of the road were flooded while those on the other side remained untouched.

Three researchers from the Queensland University of Technology jumped at the opportunity to find out how losses might affect risk-taking. Because neighbors are largely similar to each other demographically, the differences in damage provided a chance to see if risk preferences had changed -- after all, some homeowners' losses were indeed large. On average, the estimated damage per home was about AUD$80,000 (about $71,000 today) and not everyone was guaranteed an insurance payout.

In exchange for taking a quick survey, homeowners in these areas were offered either AUD$10 (about $9) or a AUD$10 lottery scratch card which had a maximum possible prize of AUD$500,000 (about $445,000).

Amazingly enough, the researchers found that "risk taking [increased] by 50% between homes where the flood was 0.75 meters below the house level and the homes where the flood was 0.75 meters above."

In other words, for homeowners that otherwise look pretty much the same, those who were directly affected by the flood were much more likely to choose the gamble over the cash. 

The possible reasons we make big bets in the face of loss
There are a variety of explanations for why we might become more risk-seeking after a loss. 

One study suggests that it might simply be an emotional response, or trying to undo the loss by setting up the possibility of a future payoff. Another study shows that there could be a difference between realized and unrealized losses, where people are more likely to take on risk if the loss hasn't been realized yet. 

In the case of our flood victims, perhaps the survey was administered before insurance payouts had been established, meaning that the homeowners were still sitting with an emotionally unprocessed and financially unrealized -- but very visible -- loss. 

Either way, if you're experiencing losses you might react by unwittingly taking on more risk -- whether it's appropriate for the situation or not. You might not think that accepting a lottery ticket from a survey-giver counts, which is hard to disagree with. But certainly choosing to double down on a stock that's been languishing at the bottom of your portfolio would qualify.  

How can you avoid emotional risk-taking?
Knowing whether you're being smart or responding emotionally is a key skill to cultivate as an investor. 

One possible solution is to establish performance metrics for yourself prior to making an investment. You can always change the rules to adjust to a change in environment, but at least having a rule will give you some structure before making future decisions.

Knowing when you're going to sell will also take away the option of keeping your losses unrealized, which could be causing you to take on new risks without your even knowing it. 

If you want to analyze a past investment more objectively, try to come at it again from the perspective of a new investor. Pretend you've never seen the stock before, and start asking all the questions you probably asked yourself at the beginning -- except stop answering the questions off the top of your head and start researching the answers. Situations change, after all. Maybe your investment is just going through a rough patch but is well-placed for the future, or maybe it's well on its way toward a bankruptcy. 

Either way, you'll only be able to figure it out if you keep a clear head and step away from your past experiences. Ignoring what's happened in the past can be difficult, but it's more effective to make decisions based on the situation you're facing today -- without the emotional baggage and unrealized expectations of yesterday. 

Another option? Consider automating your investments. Diversify more and trade less. Active trading works for some, but the overall performance of traders tends to lag that of passive investors. If you're having trouble letting go of past mistakes and analyzing new opportunities with an objective mind, you might benefit from allocating more, if not everything, to passive investments. 

That way, any "stock-picking" money you have won't be such a big source of stress, and you can play around while feeling more comfortable about the overall state of your portfolio. 

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The article Why Emotional Investors Are Hardwired for Failure originally appeared on Fool.com.

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