NEW YORK (MainStreet) Eliminating emotions when making investments and replacing it with logic by evaluating the fundamentals in a market is a daunting task for many investors.
Investment decisions are often dominated by fear, greed or by only examining short-term outcomes, experts said.
Investors are buying and selling their stocks, bonds and other funds too often instead of looking at other factors such as whether the company is growing its business, producing cash flow and creating competitive strategies, said Kyle Mowery, managing partner and portfolio manager at GrizzlyRock Capital, a Chicago alternative asset management firm.
"We focus on what is driving the performance of the stocks versus whether it is up or down," he said. "We believe in fundamental research and that is the right way to invest."
Many investors are focused only on short term gains or losses instead of long term yields, he said.
"The markets are made up of people and people are not rational," Mowery said. "There are irrationalities in the stock market, and we look to capitalize on those. People have a tendency to overemphasize information that happened yesterday that is more salient than information that happened a year ago."
Other investors focus on how the market is reacting to new information, especially geopolitical news.
"Markets tend to overreact to new information," he said. "It is hard to know if it is cyclical in nature or secular or permanent. There is a shorter term bias in the market. It can be exploited."
A better approach is to balance the risks and rewards of the investments in your portfolio, Mowery said.
"Investors should be looking for a rational, balanced approach that maximizes all of your investments over time," he said. "You want to buy your stocks like your groceries when they are on sale."
Divesting a mutual fund only because its yield has declined recently is not the right approach, Mowery said. Instead, investors should purchase one that produces better fundamentals.
"Investors should wait for it to come back up or rebalance their portfolio by taking some money out of a fund that is doing well and putting it into something that balances your risk so you can have a smoother return stream," he said.
Some investors rely on anchoring when making their investment decisions by basing it on "events or values with which they are familiar, even though they may have no bearing on the actual value," said Kimberly Clouse, private client advocate at Covestor, a registered investment advisor.
People who follow this strategy are using irrelevant information as a reference point and often increase their risk instead of their reward. One common example is when an investor buys a stock at $100 per share, but learns that the financial situation at the company deteriorates for a significant reason. The stock price then falls to $80, but the investor still hangs onto the stock hoping that it will regain its value and rise back to $100 so he can break even at the price at which it was purchased, she said.
"They anchor the value of their investment to the value it once had - $100 in this case and instead of selling it to realize the loss, they take on greater risk by holding it in the hope it will go back up to its purchase price."
Other investors follow prospect theory which asserts that losses have more emotional impact than an equivalent amount of gains, Clouse said.
Prospect theory "meets real world investing when you think about how much an investment's value might fluctuate," she said.
In a traditional way of thinking, the amount of utility gained from someone giving you $50 should be equal to a situation in which they were given $100 and then $50 was taken from them. The end result is a net gain of $50.
"Despite the fact that you still end up with a $50 gain in either case, most people view a single gain of $50 more favorably than gaining $100 and then losing $50," Clouse said. "Even though you may end up with the same amount of money in the long run, a less volatile investment may 'feel better.'"
Since people place different values on gains and losses, many of them will base decisions on perceived gains rather than perceived losses.
"If a person were given two equal choices with one expressed in terms of possible gains and the other in possible losses, people would choose the former - even when they achieve the same economic end result," she said. "Individuals should examine their own biases and attempt to improve their investment decisions. Much of this so-called irrational behavior is adaptive."
Most people handle risk and uncertainty by basing it on their emotions and personal biases, said Ron Piccolo, a professor of management at the Rollins College Crummer Graduate School of Business.
"For most people choices are informed by preferences that can be largely outside of one's immediate consciousness," he said. "In other words, choice is rarely the result of pure unbiased rational thought."
Individuals often make decisions where they engage simultaneously in risk adverse behavior such as buying life insurance and risk seeking behavior such as purchasing a lottery ticket, Piccolo said.
Since the markets will always be volatile and unpredictable, investors should study metrics or the fundamentals, said Matthew Tuttle, CEO of Tuttle Tactical Management, a Stamford, Conn. Investment firm.
"If you strip all of that stuff out and purely focus on the trends in the market, the market can actually make sense," he said.
The challenge for financial advisors is to encourage their clients to turn off their emotions, said Curtis Holden, senior investment officer at Tanglewood Wealth Management, a Houston financial planning firm. This benefits investors when they need to sell their stocks or investments before they become worthless, he said.
"Many investors suffer from loss aversion," Holden said. "People get satisfaction from seeing their money increase. The pain they feel from losing is so much greater than when it goes up."
--Written by Ellen Chang for MainStreet