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Investing: Can you take the pain?

On a day at the stock market like today we almost all feel the pain. As I write this the Dow Jones Industrial Average (the Dow) is down 130 points for the day and off 450 points in the last 4 trading days. So when the value of your mutual fund or stocks are moving strongly to the down side what are you tempted to do? Sell to stop the hemorraging or buy more because of the value. Some psychological studies can tell us which way we probably lean.

Studies done in the 1970’s have shown we feel twice pain or distress for the financial loss than we feel happiness for a gain. Let us see if I can engender some pain and gain in you. Imagine you have a mutual fund account with a value of $100,000. You get your quarterly statement and the account value has fallen to $90,000, how do you feel? A little (maybe more than a little) pain there, heh? Now you open the statement and see a $10,000 gain to $110,000. Feels pretty good, but definitely not a strong as losing that $10 grand! Leave it to psychologists to figure a way to measure phychological pain and pleasure, but the double the pain makes sense to me.

So how does this affect us as investors? From the question in the first paragraph, I think when our investments start falling in value, we are strongly tempted to sell to just stop the pain. It gives us a good idea why so many investors are so good at buying high and selling low. I know personally when a stock I have invested in goes down I start to mistrust my judgement and search the news for clues I might have missed that this was a bad investment. Doing this research will, hopefully, help me hang on to good investments when the overall market does not think much of them.

One last point we need to remember so we do not let the pain of less lead us to the poor house. A recent article submitted to Seeking Alpha did a pain vs. gain calculation. First, the average return of small cap stocks over the last 60 years is 16.3% per year and the average return for large cap stocks is 12.76%. The author used monthly returns to record a positive point for each percentage of positive months and 2 negative points for each percent negative return in negative months. The more volatile small cap stocks racked up a score of minus 788 (-788) points even as an investment would have grown to 13 times the original investment (using rule of 72). The steader large cap still gave us minus 482 (-482) pain points in spite of a 10 fold gain.

Bottom line: If you want to be a stock market investor, you must figure out a way to handle the negative emotions of negative returns. Markets go up and down, but the research shows it is much harder for us to live with the down part.

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