How to become a better investor: Avoid stress
Everyone who has ever invested money knows that financial markets can induce stress. Nobody likes to see their investments make losses but when they do, the pressure builds to recover these losses. But does this stress change investment behaviour?
I don’t think that any reader will be surprised when I say that the answer is yes.
Gesa-Kristina Petersen and Theresa Spickers used lab experiments to investigate how stress changes investor behaviour. To do this, they recruited 492 volunteers to participate in the typical artificial stock market that is used to examine the formation and collapse of bubbles. A group of six randomly selected participants are trading in a stock that in each period pays a random dividend between 0 and 0.6 ‘talers’ with an expected dividend of 0.24 talers. The participants can trade the stock between them for 15 rounds. After the 15th and last round, the game will end, and the stock will be worthless. Thus, the fair value of the stock at the beginning is the average expected dividend times 15 (the number of rounds) and drops by the average expected dividend each round till it reaches zero.
As in every experimental market of this form, share prices tend to balloon into bubbles where optimistic investors bid up the price of the shares in the early rounds, hoping for a higher dividend. As the game nears its end, the share price can no longer be sustained and the bubble bursts, sending the share price crashing to zero.
In order to examine how stressed people, behave in such a market, the researchers asked randomly selected participants to count down from a given starting number in steps of 17. Every time the participant made a mistake, they were interrupted by the experimenters, given a new starting number, and asked to do it all over again. And because the participants had to count down in steps of 17 before the other volunteers in their group it really did stress them out, as you can imagine.
Comparing markets with stressed investors to markets with more relaxed traders showed that bubbles appear in both types of markets and the bubbles were typically of similar size. However, stressed investors were reluctant to deviate from the market opinion. They were hiding in the herd. But that means that they were more reluctant to sell an overvalued stock than calmer investors, thus prolonging the bubble without making it larger. But when the bubble inevitably burst, these stressed investors were the ones more likely to be stuck holding overvalued shares. By going with the herd longer than other investors, they were the last ones holding the bag.
This provides an obvious, but important lesson. If you want to become a better investor, make sure you are not stressed when you make investment decisions. And that means turning off financial TV like Bloomberg or CNBC which are designed to stress you with a constant barrage of ‘alerts’. Similarly, social media groups, message boards, and social media influencers do only one thing. They want to keep you engaged for as long as possible and the best way to do that is to bombard you with content, stressing you out in the process. Following social media influencers or social media groups about investments is not only useless (because most of them are charlatans, in my view) but actively makes you a worse investor by robbing you of your ability to think for yourself.