Step one: Recognize -- and overcome -- the psychological hurdles that influence our behavior. By Bob Frick, Senior Editor October 11, 2011 Remember how you felt that day not long ago when the Dow Jones industrial average plunged more than 500 points over fears that a French bank might sink because of its holdings in U.S. subprime mortgages? Sacré bleu. That rout followed a 400-point surge the day before because investors had concluded that a downgrade of America’s debt rating wasn’t the catastrophe some had feared it might be. News of the downgrade had precipitated a 600-plus-point drop the day before the rally. Clearly, on such seesaw days, the markets aren’t sanely analyzing news developments and incorporating them into share prices. Rather, the markets are emotional barometers. SEE ALSO: Our "Be a Better Investor" Special Report Yes, we live in trying times, and investors should be concerned about a feeble economy and volatile, often irrational markets. But now more than ever, we need to shunt aside emotions and approach our investments with logic and detachment, and take a long-term view. This is true especially because it’s human nature “to base many of our decisions on how we feel about what’s just happened,” says Daniel Egan, head of behavioral finance for Barclays’ money management unit. The recent past—such as the stock market’s summer swoon and the 2007–09 bear market—has been anything but pleasant for investors. We tend to extrapolate what’s happened lately into the future, especially when we’re anxious. And loss of wealth is so painful to our psyches that we often sell just to make the pain go away, even if the appropriate strategy is to hang on to our investment. Advertisement Egan offers a four-step plan to help investors through what are bound to be turbulent times ahead: Don’t over-monitor. Studies show that the more we examine our portfolios, the riskier we think they’ve become. Always sleep on an important decision. Don’t make moves based on the heat of the moment. Seek a second opinion. It doesn’t matter whether the provider of that view is a financial adviser, a friend or a spouse. Second opinions provide perspective, and the most valuable ones challenge your preconceived notions. Advertisement When the market drops, view it as assets going on sale. That doesn’t mean you “start chucking money at stocks wholesale,” says Egan, but you should consider buying prudently during declines. In addition to heat-of-the-moment reactions, we need to guard against other common mental hurdles that experts say interfere with our ability to make the most of our investments. Chasing Returns Perhaps our most persistently damaging behavior is to buy what’s been hot. The notion of chasing returns refers to buying a stock, fund or other investment after it’s had a good run, selling it after its price drops, then moving on to the next hot prospect. The result: Return-chasing investors trap themselves in a portfolio-draining cycle of buying high and selling low. Every year, Dalbar, a market-research firm, releases a study that compares investors’ returns with the performance of the stock and bond markets. Standard & Poor’s 500-stock index returned 9.1% annualized for the 20-year period through 2010, but Dalbar found that the average investor in stocks earned just 3.8% a year. And the Barclays Aggregate Bond index returned 6.9% annualized for the 20-year period, but fixed-income investors on average earned 1% annually. Advertisement The top two culprits behind performance-chasing are the recency bias and the herd mentality. Recency is the triumph of emotional, short-term thinking over logical, long-term planning. Studies have shown that investors allow a variety of recent events to determine their interest in stocks. For example, a 2007 study of soccer-crazy countries found that their stock markets typically fall after the national team loses. Another study showed a tendency to want to buy a stock when it has been in the news. So when we see a stock or a mutual fund with a great short-term record, we may react reflexively and buy, although the short-term record is usually meaningless. The herd mentality has an even more insidious impact on results. The urge to follow the crowd is so hard-wired into our psyches that the pain centers of the brain are stimulated when we ignore the masses. Running with the pack—say, to minimize danger or improve our chance of finding food—made sense in the prehistoric past. But following a pack of investors who’ve made good money recently in, say, gold or Treasury bonds is asking for trouble because those assets have already had a good run, and you may be buying at or near the top. So how do we train ourselves to think independently and focus on long-term goals? Marty Martin, a financial psychologist at Aequus Wealth Management Resources, in Chicago, says he tries to combat the herd instinct in his clients by showing them graphs with the ups and downs of markets and asset classes over long periods. At first, clients may think they see patterns they can bet on. If they do, he asks them: “What do you think will actually happen to that investment in the future? Not hope will happen.” In other words, given the random ups and downs plainly evident on the graphs, can you say with certainty what the next move will be? The best way to deal with the dangers of return-chasing is simple: Build a diversified portfolio and rebalance it regularly. Rebalancing forces you to cut back on investments that have been performing relatively well and to buy those that have been relative laggards—in other words, it forces you to buy low and sell high. Advertisement House Money Making a killing isn’t all it’s cracked up to be. In fact, reaping a big gain may set you up for a fall because of the house-money effect. Think about walking into a casino and, on your way to the roulette table, dropping a spare quarter into a slot machine, which comes up cherries and gushes out hundreds of dollars in change. The house-money effect says that when you reach the roulette table, you’re more likely to make riskier bets than if you hadn’t just pocketed a windfall. The evidence for the house-money effect is clear. Experiments show that 77% of subjects who were given $15 would accept a coin toss to win or lose $4.50. But just 41% of subjects who were given no money would take the bet. Studies show that professional traders who clean up in the morning are more inclined to make riskier trades in the afternoon. The recent real estate bubble provides evidence of the house-money effect at work on a grand scale. Many homeowners, feeling flush as the value of their properties skyrocketed, extended themselves by running up their credit cards, taking out home-equity loans and buying second homes. The house-money effect wreaks havoc on individual investors, says Richard Peterson, a psychiatrist whose MarketPsych firm studies investor biases and advises clients how to beat them. Peterson has found that investors’ loss-avoidance instincts recede after they make big gains. “You’re not only excited about the gain; you lose your ability to detect risk,” says Peterson (use his firm’s software to assess your own biases and see some suggested cures). One way you’re more likely to boost risk is to simply hold on to your winning investment, Peterson says. The risk is that a single investment or type of asset—think real estate, gold, Internet stocks—becomes an outsize portion of your portfolio. Although the house-money effect and return-chasing are different problems, the solution is the same: Diversify and rebalance. If you don’t have the discipline to rebalance, hire an adviser to help you. Or invest in a mutual fund that holds multiple kinds of assets and rebalances them automatically, such as a target-date fund. Paralyzed By Fear Ever notice that the golfer who stands over the ball longest usually hits it the worst? It’s not that he’s striving for a Zen-like calm before swinging; it’s that he’s afraid to hit the ball. The same phenomenon occurs in investing. Fear of making errors induces paralysis and causes many people to sit on cash that should be invested, or to hold on to losing positions that should be closed out. The reason is plain: Losses hurt. Experiments have shown that the pain of losing is twice as great as the pleasure derived from winning the same amount of money. This loss aversion can paralyze investors to the point where “they don’t care about being right anymore—they just don’t want to be wrong,” says Shlomo Benartzi, a professor at the University of California–Los Angeles and chief economist at the Allianz Global Investors’ Center for Behavioral Finance. Complicating matters is a phenomenon known as mental accounting, which has us wired to judge our success or failure by looking at our gains or losses up till a certain point. Research has found, Benartzi says, that people are “exquisitely sensitive” to a reference point. With a gambler, the reference point is his initial stake. With an investor, it could be the level of the Dow industrials when she plunked her money into the stock market. Benartzi suggests using “fuzzy” mental accounting to our advantage. For example, instead of investing a lump sum all at once, he suggests dividing it into four equal parts and investing each portion gradually—say, some every three months. That strategy makes it more difficult for the investor to identify an obvious reference point and makes loss aversion “much less likely to kick in,” Benartzi writes. Who knew dollar-cost averaging offered such keen mental benefits? Overcoming procrastination requires a different strategy, which Benartzi calls precommitment. He suggests that advisers ask clients who have abandoned stocks whether they’re willing to go back into the market in the future. If the answer is yes, the next question is “When?” Once the client has chosen a date, he now feels in control and has made a commitment to invest. Those two ingredients—control and commitment—can spur even a reluctant investor to act. Setting goals without an adviser or other confidante is tough. But help may be as close as your employer or a mutual fund company. If you participate in a 401(k) plan, you can have your employer regularly deduct a set amount of money from each paycheck. Or you can set up regular transfers from your bank account to a fund.