Recognizing the Emotional Cycle of the Investor’s Dilemma

The chart below illustrates the emotional roller coaster underlying the Investor’s Dilemma. You will probably recognize some of the emotions. If an investor’s account balance increases, he tends to feel happy, while if the account balance decreases, he will be unhappy and may lose confidence in his investment strategy. When an investor lacks confidence, he may be driven to sell (inevitably at a low price because of all the other investors just like him who are acting on emotion) and make other unwise changes to his portfolio. Most investors don’t realize when they’re caught in this cycle.

Similarly, when a fund manager’s predictions about the market prove incorrect, he may lose confidence in his decisions and make unnecessary changes in his clients’ portfolios. Although these changes may be motivated by a desire to protect the investor, making hasty changes breaks one of the key rules of sound investing, and almost invariably results in lower returns.

investor psychology

The desire to limit losses is a perfectly reasonable, but it brings the investor back to the beginning of the cycle, which begins with fear. If that fear had led an investor to cash out early in 2009, he would have missed the mid-2009 rally. That’s why Buy and Hold is one of the key rules of investing.