Question

Scenario #1: Kenny is ready to implement the investment policy portion of his financial plan. After months of dragging his feet, he began by allocating into a well-diversified portfolio that his financial planner artfully crafted for him, across a myriad of asset classes. Days after he invested into his portfolio, in accordance with his long-term goals and risk profile, the stock market suffered a big drop. The economy wasn’t in peril, or even a recession, but the market just experienced a normal, run-of-the-mill “correction” that happens from time to time over the short-term. Even though Kenny’s portfolio only has about 50% of its assets in stocks, he is scared. He feels like he has just been through the ringer, and he is only a few weeks into his long-term plan! How could this be? His planner told him that there would be “days like this,” that his plan is built for the long-term, and it is inline with his goals and risk tolerance. Further, he told Kenny that he will only experience about half of the downside as the stock market itself (since half of his portfolio is out of the stock market), yet he still feels like he made a bad decision. He wants to sell everything at once, so he picks up the phone, screams at his planner, and forces him to sell everything that just went down. 1) What behavior/bias is present? 2) Why is this behavior detrimental? 3) What could have been done differently, or what could be done differently next time to avoid this result?

Answer 1

This is overreaction towards the decline in the market. It depicts high degree of loss aversion and fear of losing all investment by judging the short term changes in the market.

This reaction is detrimental because the price decline is only short term and can rise soon.Also he will have a loss on the investment because the stocks will be sold at a loss.

Next time he should wait for a while and have some risk taking streak to play in the stock market. Higher risks will bring in higher gains.