Like every other investor, you prefer not to see the value of your investments drop.
But at some point they will fall simply because of the ups and downs of the market. And how you respond to short-term losses can help determine if you enjoy long-term investment success.
Investors’ feelings about losses can be complex. In the field of economics, an area of study is devoted to “loss aversion” — the concept that people dislike losing money so much that, given a choice, they’d prefer to avoid losses rather than take gains.
For example, if you have a high degree of loss aversion, then you will find greater dissatisfaction by losing $100 than you’d get satisfaction from taking a $100 profit.
Loss aversion can lead to various forms of negative investment behavior. Here are two of the most common results:
Seeking “risk-free” investments — When you think of investment losses, the first thing that probably comes to mind is a drop in stock prices.
If you’re really loss-averse, you might seek to avoid this situation by simply avoiding stocks and placing all your money in other investments. While some of these investments may seem “risk free,” you must consider factors such as inflation risk — the possibility that these investments may provide returns that don’t keep up with the rate of inflation.
Holding “losers” too long — From time to time, you will own investments that, for whatever reason, underperform. If you’re highly loss-averse, though, you may have a tough time acknowledging the losing nature of these investments, so you may be tempted to hold on to them until they “bounce back.” But if the investment’s fundamentals change, it may be time to sell it and look for other opportunities.
Conversely, you may want to hold on to quality investments whose price has dropped in the short term, because these investments may well recover.
How can you avoid these types of behavior? For starters, you’ll need to recognize the symptoms of loss aversion in yourself.
Accept the fact that short-term losses are part of investing and that every investment carries risk. This doesn’t mean that you should do nothing to reduce your risk.
One effective risk-fighting measure is diversify your holdings by investing in a variety of vehicles.
If you had all your holdings in only stocks or bonds, a downturn affecting one of those assets could lead to a big hit for your portfolio. But by spreading your dollars among a variety of investments, you’re also spreading the risk.
Keep in mind that diversification by itself can’t guarantee a profit or protect against loss. Investment losses, even short-term ones, aren’t much fun, but by not overreacting to these losses, and by diversifying your portfolio, you can look past today’s losses toward tomorrow’s possibilities.
Scott Flake is a financial adviser with Edward Jones. He hosts regular investment discussions. For more information, call (928) 468-1470. This article was written by Edward Jones for use by your local Edward Jones financial adviser.