Don't Eat the Marshmallows
by John M. Grund
Most of us can become better investors by psyching out our own mental quirks.
Give a marshmallow to each kindergartner in a classroom and tell them that you're going to leave for 10 minutes, and if they still have their marshmallow when you return, you'll give them another. Many of the children simply won't be able to resist the temptation, and will swallow their marshmallow before you get back, even though eating the one in hand means giving up the marshmallow, figuratively speaking, in the bush.
Of course, as grownups we have learned to prefer a greater, but delayed, gratification over a smaller, but immediate one, right? We know how to balance risk and reward and make rational decisions with our investments.
Nah. A growing body of research suggests that most of us manage our money in decidedly quirky ways. Economists who mix behavioral psychology into traditional theories are creating a new field called behavioral finance. Its insights might make you a more successful investor.
For example, researchers have found that, for most of us, the pain of losing a dollar outweighs the joy of gaining one by about two and a half times.
The researchers didn't attach electrodes to people's wallets. Instead they asked people if they were offered a bet on a coin, and a losing flip would cost them $100, what amount would a winning flip have to bring to convince them to wager? The usual answer: About $250.
Our aversion to losses, mixed with our tendency to hang on to losing stocks so we won't have to acknowledge making a mistake, means that most of us sell our winners instead of our losers. But that's consistently the wrong play.
Other research has shown that the winners we sell outperform the losers we keep by an average of 3.8 percentage points in the first year.