Stocks: 4 reasons we feel worse than we should

AP

(MoneyWatch) May was a bad month for stocks, and the first day of June wasn't too good, either. Bad job news hit markets hard. Yet the Vanguard Total Stock Index Fund (VTI) is up 2.5 percent for the year. At this pace, it would turn in a 5.9 percent return for the year. Not horrible, not great, but better than last year.

So why are we wallowing in pain and pessimism about the market? Here are four possible reasons:

1. Prospect theory. Research shows that people experience about twice as much pain from losing a dollar as they get pleasure from gaining a dollar. On April 27, the total U.S. stock market was up 12.2 percent for the year. Let's call that 12.2 units of pleasure. Then markets gave up 9.7 percentage points of that pleasure. Since losses cause pain that is twice as strong as gains cause pleasure, we have to deduct 19.4 units of pleasure (-9.7 percent x 2). Thus we are left with a -7.2 units of net pain.

2. Recency bias That refers to the tendency for people to count recent data as more important. And because the market loss is more recent, it hurts a bit more. If stocks had fallen early in the year by 12.2 percent and then recovered to a net 2.5 percent gain, we would be feeling much better even though our wealth would be the same.

3. Vividity. The faster something happens, the more we notice it. Though it took nearly four months for stocks to record that 12.2 percent gain, it took only a bit over a month to lose most of it. That's why investors felt the  plunge in 2008 and 2009 so intensely. The plunge was no worse than the decline that followed the Internet bubble, but the shock and awe factor of everything happening so fast caused excruciating pain.

4. The media. The Dow Jones Industrial Average (DJIA) is in the red, down 0.8 percent for the year. Of course theDJIA is a silly index of a mere 30 stocks that strips out dividends and is weighted in such a way as to defy any logic in today's world. Yet it's what the media quotes.

My advice

Perception can be more powerful than reality. Don't let perception push you into doing dumb things like panicking and selling on market dips. Though it is an all too human a reaction, how did that work for everybody in early 2009? Not too well. History will only repeat itself if we let it.

  • Allan Roth On Twitter»

    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.