Tips for the Irrational Investor: Stocks, Bonds, IPOs and Baseball
Jason L. Harman, PhD

But shouldn’t we be aware of how our stocks are performing? What if a stock turns out clearly to be a bad investment? It’s true that, generally, more information is considered better when making decisions. How can we reconcile this need for information with our tendency to overreact to losses? Recently David Hagman, Cleotilde Gonzalez (two colleagues at Carnegie Mellon University) and I were interested in this question and we ran an experiment to see if we could help people make better investment decisions. We had participants play a game for real money in which they made repeated decisions between two options. One option was like a stock; it gave you a large amount of money sometimes, but nothing other times. And the other option was like a bond; it gave you a modest amount of money all of the time. The stock would give out more money on average and participants knew how much each option would give them with what probability.

One group made decisions, but never received feedback about whether the risky stock option gave them the large payout or zero on any trial (like someone following the advice “set it and forget it”). A second group received feedback on every trial, knowing exactly which outcome the stock gave them after each choice (like someone watching their stock every day).  A third group received no feedback for ten trials, but every ten trials we showed them the results from each of their previous ten choices (giving them full feedback like the second group, but with a delay). As we expected, the first group made more money than the second group. Receiving feedback after every choice caused the second group to overreact to trials where the stock paid out zero. Importantly, the third group made just as much money as the first group. Although they received feedback about each of their decisions, viewing them alongside other outcomes allowed participants to have full information without reacting to random losses.

So, if you’re investing for the long term, a diversified portfolio of stocks may be a good choice. You don’t need to completely ignore how your stocks are doing, but if you look at several returns over a period of time, you can help yourself avoid overreacting to temporary losses and gain more over time.

 

 

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