Recall the socialization of investing discussed in Chapter 7. You like to talk about your investments. You compare your investments to those of your coworkers, friends, neighbors, and even strangers. Your decisions become based on other investors' opinions. This investment chatter also affects the memory of your past investing experiences.
What people remember about the same event is often different. In a court of law, multiple witnesses to an event will frequently recall details that conflict with each other's accounts. Yet, when you talk about an event with other people, your memory of it will change to be more consistent with the perceptions of the other people. Socialization causes a converging of recalled perceptions within the group. It's interesting that the changes do not necessarily lead to a convergence to reality. In other words, after socialization, the recall of the people in the group can be more faulty than before. This is why witnesses that are going to testify in a trial are not allowed to hear the testimony of other witnesses.
When you participate in investment socialization, you learn what others remember about both the stock market and their own performance. Imagine several people suffering from cognitive dissonance, all trying to ignore bad news and focus on good news. When this happens, you hear a lot of good news and not much bad news. With all this good news, your investment performance must have been good as well—at least that is how you'll remember it.
The pleasure of achieving gains and the pain of suffering losses are powerful motivators of our behavior. However, it may be difficult to determine whether some investment transactions are considered a profit or a loss. For example, Bob purchases a stock for $50 a share. At the end of the year, the stock is trading for $100. Following good investment principles, Bob re-examines his investment positions at the end of the year in order to record and determine his net worth as well as to monitor the progress he has made toward his financial goals. Six months later, Bob sells the stock for $75 a share. He makes a profit of $25 a share. However, the profit is $25 a share lower than it would have been if he had sold at the end-of-year price. Clearly he has made a profit of $25 a share. However, does Bob feel like he has made a profit or does he feel like he has lost money?
This issue deals with a reference point A reference point is the stock price that we compare to the current stock price. The current stock price is $75. Is the reference point the purchase price of $50 or the end-of-year price of $100? The brain's choice of a reference point is important because it determines whether we feel the pleasure of obtaining a profit or the pain of a loss.
Early investigations into the psychology of investors assumed that the purchase price was the reference point. However, investors monitor and remember their investment performance over the period of a year. If the purchase was made long ago, then investors tend to use a more recently determined reference point.
What recent stock price is used as a reference? Possible recent references are the mean or median price of the past year. Additionally, the 52-week high and low prices are commonly reported in the media.
It appears that the most likely reference point used is the highest price of the previous year. Returning to the example, Bob probably feels like he has lost money because he had moved his reference point to $100 when he recorded that price in his end-of-year evaluation. If Bob feels that way, he may not sell at $75 because he would want to avoid regret (Chapter 5). He may wait until the stock price moves higher again so he can break even (Chapter 6). In your mind, the reference point determines whether a position is at a profit or loss. However, you periodically update your reference point to reflect unrealized profits.
You may use other reference points. Consider the social aspects of investing discussed in Chapter 7. Your reference point may be a comparison with others. As Figure 10.2 suggests, you sometimes think of investing as a competition. How was your return last year? Did you beat the market? Or, maybe more important to you, did you beat your coworkers, neighbors, and relatives?
Investing is not a race. It is a method of achieving financial objectives that lead to a better lifestyle. Of course, that doesn't sound like very much fun.
This chapter has illustrated that your memory is more a recording of emotions and feelings of events than a recording of facts. This can cause you to misrecollect the actual events or even ignore information that causes bad feelings. But memory can affect you in other ways as well. Chapter 11 shows how your memory of one event, like an investment, can affect your perception of another.