Behavioral Finance: The Pseudo-Certainty Effect

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Education InvestingWe all make mistakes when it comes to our finances. Few of us manage to create the perfect portfolio on the first try. Indeed, investing requires a little tweaking along the way. While it doesn’t have to be a complicated process, investing does have its difficulties — especially when you get in your own way.

In behavioral finance, one of the ways that investors can muck up their portfolios is with the help of the pseudo-certainty effect.

What is the Pseudo-Certainty Effect?

Here is how Investopedia defines the pseudo-certainty effect:

Investors will limit their risk exposure if they think their portfolio/investing returns will be positive – essentially protecting the lead – but they will seek more and more risk if it looks like they are heading for a loss.

This is, essentially, the exact opposite of what investors should be doing. In reality, investors should be willing to take on more risk when their portfolio is doing well. It’s a good time to try to create more money. If the portfolio is doing poorly, more risk shouldn’t be incurred; instead, a measured approach to determine if something has changed in the fundamentals should be taken. You might need to re-allocate your assets at this point, but you shouldn’t do anything rash with your investment portfolio.

Pseudo-certainty represents one way that fear can rule your finances and hold you back.

When you are ahead with your portfolio, you might be afraid to change things up. You don’t want to risk a good thing. However, if you are behind, it is tempting to take on a little more risk in order to “reclaim” the capital you’ve lost. You’re driven by fear to make decisions that don’t quite match up with your risk tolerance.

How Do You Battle the Pseudo-Certainty Effect?

In many cases, pseudo-certainty affects those who pay a lot of attention to their portfolios, and trade a little more frequently. Many buy and hold investors don’t have to worry about this effect because they aren’t constantly looking into their portfolios.

Battling the pseudo-certainty effect requires that you know yourself, paying attention to what is driving you. Before you make decisions with your portfolio, stop and consider the situation, and acknowledge the why behind your adjustments. If fear (or especially panic) is one of your main motivations, you need to calm down and wiat to make a decision when your head is clearer.

Another way to battle pseudo-certainty is to create a long-term investing plan that you can live with. If you are investing in carefully chosen funds with an eye toward asset allocation, and you have a plan to help you stick with that asset allocation all the way through retirement, you are less likely to second-guess yourself. You’ll be more able to get through the difficult financial markets without panicking, and you’ll be better able to stay the course in general.

What do you think? Do you trade under the influence of the pseudo-certainty effect? What is your approach to long-term investing? Do you stick with your plan?

(Photo: Chris Potter)

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