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Why Do Investors Underperform the Stock Market?

Seth Jentner10/17/2013

Many studies show that most investors underperform the long-term returns of the stock market. How can this be? Apparently, it is not only investment-manager behavior that contributes to this underperformance. It is also investor behavior that contributes.

According to neuroscientific research, one weak link is our memory. Research indicates that our brains simply don’t have the capacity to hold in long-term memory every detail of what we’ve experienced. Much detail can be held in short-term memory, but after a while, only a general outline, along with a few specific details, remain in our memory. Then, when we recall those memories, our brains reconstruct them based on, not only, what it has stored but, also, with information from our current set of beliefs. This often distorts our memory of what actually happened.

Researchers say it is more common to remember pleasant experiences than unpleasant ones. For investors, that can mean recalling our winners but not remembering our losing decisions.

Additionally, highly traumatic memories persist. Many of the Depression generation, for instance, never got over the stressful memories they had of the 1930s and were generally more risk averse when investing than were subsequent generations.

Investors can overcome these memory flaws by using written investment policies and keeping written investment diaries. An investment policy documents your goals, risks and rules for investing. Frequent consultation with it can help prevent making short-term investment decisions that conflict with your long-term goals. This can help avoid the bias of hindsight and can help correct misplaced fear or overconfidence. Such a record helps you determine whether your wins are due to skill or just plain luck.

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