People have a tendency to overreact during good times and bad – but we shouldn’t let those bad days negatively affect our investment decisions.
In my research, I’ve found that financial losses can trigger our brains to form overly pessimistic views about our investments. Our brains are programmed to avoid the things we believe could be bad, and the way we learn actually affects our decisions. If you add in the all-too-real risk of losing your money, the effects of these pessimistic views are even greater.
This is when overreacting after negative payoffs can lead to inaccurate views about the future.
The different ways our brains learn from good and bad experiences make up what I call asymmetric learning. The negative perceptions we develop as a result lead to a pessimism bias.
I set out to examine the influence of asymmetric learning on investment decisions by conducting a study with two sets of financial decision-making tasks. I wrote about my findings in “Asymmetric Learning from Financial Information.”
This concept of asymmetric learning can be applied to many financial decisions, ranging from the impulse sale of a low-performing stock to reconsidering investing in your education during tough economic times. And the problem with this under investing is that it keeps you in a bad situation.
When it comes to recessions, the adverse effects of pessimism bias and asymmetric learning can even prolong a bad market. Investors might even be too weary to take advantage of buying low.
So the next time some of your stock investments tank, don’t take those frustrations out on your portfolio.
By Camelia Kuhnen, professor of finance