Understanding the Investors' Dilemma Part 2

In part one I wrote about The Investors Dilemma, the cycle that explains why many investment decisions are driven by emotional and psychological biases that may be inconsistent with an investor’s long-term goals. This week I am going to explain the components that make up the cycle.

Fear of the Future: The cycle begins with a sense of uncertainty about the future, characterized by questions like: “Will there be enough money to maintain my standard of living? How much do I need to save? How do I know what is the best investment?” The media and advertisers prey upon this fear of the future in an effort to sell products.

Forecast and Predict: Because of this fear of the future, investors have a strong desire to comprehend and predict future events. If someone could tell what is going to happen with inflation, long-term interest rates, share prices, and overseas markets, there would be less to fear about the future from an investment perspective. Along these lines, investors are frequently convinced that someone has the information, power, and insight to forecast the future.

Track-Record Investing: The primary method investors employ to convince themselves that the future can be foretold is through track-record investing. This means they look for stock managers who have performed better than the market in the past with the hope that they will continue to have superior performance in the future.

Information Overload: In the past, gathering information was the best way to guide prudent investment decisions. However, the current Information Age has created access to so much information that it is easy to become overloaded. Investors feel compelled to understand all of the information: the Internet, books, newspapers, magazines, TV talk shows, advertisements, friends’ experiences, etc. Indeed, instead of reducing fears, this deluge of information often intensifies doubts about investing.

Emotion-Based Decisions: As investors, we never overcome our own humanity. Even though most investors prefer to think that they make investment decisions based upon logic, typically emotions, such as trust, loyalty, hope, greed, and fear, drive our investment decisions.

Breaking the Rules: There are three commonly accepted rules of investing: 1) Own equities 2) Diversify and 3) Rebalance. And, the golden rule of investing is: Buy when prices are low and sell when prices are high. It sounds simple. However, when investors make decisions based on emotions, they wind up breaking these seemingly simple rules, thereby sabotaging their portfolios.

Performance Losses: Performance loss means investors fail to capture the returns they expected. Unfortunately, because investors so frequently break the golden rule of investing, they do not receive the rate of return they expected. Investor performance does not equal investment performance. When this effect is compounded over a period of years, an investor’s potential for reaching financial goals is significantly decreased. Such loss creates additional frustrations and fears about the future, once again initiating the cycle.

THE RESULT: Not Enough Money and No Peace of Mind

The end result of the Investors’ Dilemma is not having enough money combined with worry, frustration, and anxiety about the inability to accomplish meaningful life goals.

Check back next week to learn how to Break the Cycle.

Join me this and every Saturday morning at 10AM for "it's Your Money", part of Coaches Corner, Saturday Morning Street Smarts, on Newstalk Radio, WBLF, 970 AM. Call in during the show: 814-272-9700 or send me an email: Paul Nichols