Behavioral Finance and Loss Aversion

it’s often said that the two primary emotions exhibited by investors is greed and fear.  Those emotions are exhibited at various times and one of them is when portfolios need to be rebalanced.  After a great year in the market some investors are reluctant to sell securities that have appreciated a lot.  It is common to believe that stocks that have gone up a lot will continue to go up.   This is known as “chasing the hot hand.”

But this characteristic is also exhibited after a bad year in the market.  After a steep decline in stocks the typical investor is dead set against re-balancing to bring the stock portion of the portfolio back to the asset allocation guidelines.  This is an example of “loss aversion” and causes people to be overly fearful of losses, imagining that he will lose all his money.  This is why using a portfolio manager who has learned how to overcome his emotions and stick to a strategy is so important.

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