Do You Suffer From The Ostrich Effect?

A letter just arrived at your doorstep.  It’s your financial statement.  What do you do?

Before you answer, imagine that the market has been on a massive bull run and you are fully invested. 

Chances are, if you are like most people, you will be scrambling to open the letter as quick as you can.  And you’ll be thinking to yourself “I’m rich, I’m rich!”

But if you suffer from the Ostrich Effect, you will probably react in the exact opposite way during a bear market.  In fact, there’s at least a 50/50 chance, you will stick your head in the sand and completely ignore the statement altogether.  After all, it is easier for us to treat a risky situation by pretending it doesn’t exist at all!

Research conducted by Galai and Sade in 2006 noted that the Ostrich Effect can influence levels of interest in financial portals too!  For example, entrance to a leading financial portal in Israel was positively correlated to the financial markets.  And further research by Loewenstein and Seppi showed that, in Scandinavia, people reviewed their financial statements 50%-80% less frequently during bad markets.

When we boil down our nature to its simplest form, we just hate to feel pain.  That’s why the Ostrich Effect is so pervasive.  It is a way of pretending the losses aren’t there, even if there is no way to eliminate them.

But it’s not all bad if you suffer from the Ostrich Effect.  On the other end of the spectrum, overconfidence can lead to a tendency to trade too frequently, which other researchers have shown can reduce net returns.  One obvious reason is that excessive trading will result in exorbitant accumulated commission costs.

A self-imposed commitment device is one approach to ensuring you don’t suffer from the Ostrich Effect.  For example, you could set up monthly reminders to review your statements.  In the interim, it’s best to learn as much as you can about capitalizing on market opportunities when a correction is taking place.   As stocks drop ever lower, the irony is that the reward/risk ratio can look ever more favorable.  It doesn’t necessarily mean buy a stock that is falling, but it does mean put it on your watchlist at the very least so that when it turns around you will be well positioned to take advantage of it.

Often a stock that is trending in a certain direction will continue in that direction when momentum builds in the investor community to drive the stock ever lower.  But eventually, unless the underlying company is afflicted with some fundamentally catastrophic concern, a wave of panic selling will frequently occur, which is just the time to pounce.  And if you had your had in the sand, those are the opportunities you would miss all too easily!   So, use whatever commitment device you need to ensure you regularly review your statements and take better control of your financial future.