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How to be a better, happier investor

Recording artist Daniel Powter was having a bad day - for much of the summer of 2006. At least that's what his popular song told the world.

Anyone who has invested in the stock market can sympathize because they, too, have probably seen their fair share of bad days.

The market's gyrations give nearly everybody a case of emotional whiplash. One trick to succeeding as a long-term investor is learning how to reduce the inevitable psychological swings.

The accompanying graph shows the growth of the S&P/TSX composite index (with dividends reinvested). As you can see, the long-term has been highly favourable to Canadian stock investors. Even the last couple of decades - which have seen a few grisly bear markets - turned out okay for patient cost-conscious investors.

S&P/TSX Composite gains
[larger version]


If the long-term returns from stocks have been good, why can it be so hard for investors to sleep tight? It comes down to psychology. We feel the sting of losses about twice as strongly as we feel pleasure from gains. This quirk of the human mind is called loss aversion and was demonstrated by Amos Tversky and Daniel Kahneman, two of the pioneers of behavioural finance.

The emotional toll exacted by loss aversion can cause problems when you track every twitch of the markets. After all, the chance that stocks will rise, or fall, on any given day is about equal. But since losses lower happiness much more than gains boost it, following the market's day-to-day fluctuations becomes a recipe for depression.

Matters become worse if your memory is good and you notice when your portfolio reaches new highs. While it can be fun to see your wealth climb to new peaks, portfolios often trade well below their former highs. This is amply demonstrated by the other graph, which shows down periods for the S&P/TSX Composite total return index. More often than not, stocks are depressed when measured against their former highs.

S&P/TSX Composite downside
[larger version]


The upshot of all this is that you should mentally prepare yourself for the overwhelming likelihood that, as a stock investor, your portfolio will see a great many bad days even if your long-term results are good. Indeed, you'll likely spend much of your life with a portfolio that has declined from its prior peak.

Mental discomfort is the price you pay to obtain good returns. Unfortunately, few investors are actually prepared to pay that price in practice.

If you were scared out of the markets near the lows of 2001 or 2009 then investing in stocks is probably not for you. (Think of the experience as an important - and likely expensive - lesson. And be sure to remember it.)

But even those with stronger stomachs should resist the urge to look at their portfolios every day. It's a recipe for unhappiness that may prompt you to play Mr. Powter's song far too often.

First published in the Globe and Mail, May 18 2012.

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