From the Archives: Investor Overreaction

Investors overreact to good and bad short-term results.  So says Morningstar in their article “Why Your Results Stink.”  A quote from the article:

Why do investors make such a mess of things? In short, because of volatility, emotion, and a focus on short-term results. Volatile funds push all the wrong emotional buttons. When they go way up, we get greedy and buy. When they go way down, we despair and bail out. And we read too much into recent performance.

Destructive investor behavior has been well-documented and yet it persists.  Why?  My guess is that it is because most investors are operating without any kind of systematic framework for decision-making.  Creating a systematic process demands much more work.  You have to start with a theory and then do extensive, rigorous testing to see if your hypothesis holds up.  Even when it does, you will see quite clearly that your strategy is not always optimal–there will be certain quarters and/or certain market conditions in which it will perform poorly.

For some reason, investors have a hard time with this.  They don’t just want to win over time; they want to win all the time.  In their quest to avoid the psychic pain of occasional losses, they react emotionally with predictable long-term results.

With a systematic process in place, on the other hand, you’re not a loser just because you will lose periodically; you tend to be a loser if you quit before giving the process adequate time to work.  There are no guarantees in investing, but reacting emotionally is usually a route to poor results.

—-this article was originally published 10/13/2009.  With year-end performance results coming out shortly from many managers and mutual funds, this is the prime season for overreaction.  Bad year, dump the manager.  Good year, double up.  That’s how investors pile into the hot asset classes right before they blow up—or bail out of the styles that are poised for good performance going forward.

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