In a Financial Planning article titled “Investing Should Be Painful,” founder of research firm Wealth Logic, LLC Alan Roth writes, “I suggest telling clients to embrace the pain and take it as a good sign.” This approach reflects insights from psychology and behavioral finance. The “pain” Roth is referring to comes from going against the cognitive biases of the human brain. Borrowing from Nobel Laureate Daniel Kahneman and others, Roth describes the more automatic and emotional “system 1” thinking (in contrast to the slower, more effortful and logical “system 2” thinking) as the source of the pain investors feel when buying as prices plummet or selling as they near their summit. Roth admits he is not immune: “financial theorist William Berstein described my feelings perfectly when he told me the best financial moves he has made typically occurred when he wanted to throw up.”
Roth highlights concepts such as “recency bias” (expecting the recent past to continue) and the “herding effect” (“we all like to believe we are contrarians . . . we are herd animals”) and notes that the emotion-laden “system 1” often fools us into believing we are being logical. He tells investment advisors that to apply these insights for clients in late 2008 and early 2009, “I asked if they thought it was more logical to buy or sell stocks after a half-price sale.”
Roth reminds us that “System 1 typically prevails in investing . . . we buy more stock funds near the top price and sell more near the bottom.” Bucking this tendency, Roth writes, requires “working through the pain.” He suggests: “if we can get our clients to embrace the pain and then apply System 2 thinking, we’d provide sound service to them.”
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