Stock investors, riveted by recent market gyrations, need to resist emotional responses and the herd mentality when investing, an expert in neuroeconomics and a financial adviser said Tuesday.
After tumbling 588 points, or 3.6 percent, Monday amid a global sell-off, the bellwether Dow Jones industrial average rebounded, climbing almost 3 percent late yesterday morning only to falter at the close, shedding 1.3 percent.
All too often, our embedded mental processes work against us as investors, said Paul J. Zak, director of the Center for Neuroeconomics Studies at Claremont Graduate University in California.
"We're highly social creatures," he said. "When we see other people doing things that seem like a good idea, we do it, too. [But] if everyone is drinking Kool-Aid laced with poison, that's not a good thing to do."
The investment equivalent could be selling when the market is down more than 1,000 points in an hour -- and missing the rebound. Or buying overpriced Internet stocks shortly before the tech bubble burst.
Zak proposed strategies designed to minimize the role of emotions when investing:
Buying low-cost index funds that offer diversification and allow investors to ride out market swings;
Handing the portfolio to an investment adviser who is less emotionally engaged in the outcome;
Setting up rules in advance on when to buy and sell an equity based on a rational assessment of its value.
David H. Schwartz, a Great Neck financial adviser, said Tuesdaythat his firm, FCE Group, seeks to minimize investors' mental trauma by allocating a large portion of their portfolios -- often 50 percent -- to prosaic, but relatively safe, bonds.
"The whole concept of investing is to stay the course," he said. "The boring part of your portfolio [bonds] becomes your safety net."
For those in the equity markets, Zak said that resisting the pull of the herd can be difficult.
"Your brain gets stressed if you're taking the contrarian view," he said. "Professional traders have an advantage over individual traders because they've seen more market volatility."
Zak said he has three-quarters of his personal portfolio in index funds. For the part that he actively manages, Zak said that when he buys a stock, he writes down a forecast of at what level the equity would be fully priced.
"I'm not saying it always works," he said. "The problem with rules is you have to know when to break them. That's the trick in life."