Why You Should Be Careful About Reference Points When Investing

One of the biggest weak points for an investor is the emotional component to watching your money rise and fall. Most investors underperform the market, and a big reason for that is emotional investing. People tend to buy into the market when it rises for fear of missing out on gains, and then they sell when the market drops because they panic. Buying high and selling low is a sure way to lose money.

Investment decisions should ideally be made in a clear-headed, logical way, but that’s not easy to do. Watching an investment recede from a high point can be a big emotional drain, even if it is still up overall since you purchased it. I experienced this myself recently with the stock Fiverr (FVRR). Fiverr is a freelancing platform that my wife and I both use (you can read about my wife’s experience with it here). Like many online service companies, the stock took off after the country locked down because of COVID-19, and I decided to buy in about six months ago. This is how the stock performed over the past six months:

As you can see, FVRR is up quite a bit since I bought it (my purchase price was around $160), but it’s a very volatile stock. The stock regularly goes up or down $10 in a single day (3-6%), so it can be quite a nerve-wracking stock to hold. It also shot up $100 in February before crashing down over $100 in March, which was at first exhilarating and then depressing. This is where reference points come in.

A reference point in the context of investing is the time and price you compare your investment’s progress against. When you first buy a security, the reference point is your purchase date and price. However, once the price begins to move, the reference point tends to shift in our minds. If the price goes up, our reference point tends to move along with it. If, on the other hand, the price drops, our reference point tends to remain at the previous high point. This is because we feel like the security should continue to increase in price and any decrease is a setback to that goal. We may also create a secondary reference point at the bottom of a crash so that we can feel at least partially good about how well an investment has done since its recent lowest point.

For instance, in the case of FVRR, my reference point rose with the stock price up to about $325, and ever since the price dropped, I have continued to compare the current price with that high point. I also set a secondary mental reference point at the low point after the crash, slightly below $200. Ever since then, despite being up 37% overall, I keep thinking, “Well, at least it’s recovering but it still has about $100 to go.”

However, this is not how investing works. No security is guaranteed to continually appreciate indefinitely. For this reason, we should not be constantly adjusting our reference points. This only leads to emotional turmoil. Instead, the only reference point should be the initial one. This doesn’t mean that you shouldn’t be reevaluating your investments periodically, but in the end, the only points that matter are when you buy and when you sell.

Now, keep in mind that it’s not just the price that matters; the duration of time you hold an investment is equally important. You should always look at your investments in terms of return/time. An investment that yields 50% over 10 years (5% annualized) is not as good as an investment that yields 10% over 1 year. There’s also the issue of taxes. Capital gains resulting from the sale of a security held for less than one year are taxed at a higher rate than if the security had been held for more than a year.

In summary, be careful with mental reference points when investing. Ideally, try to keep your reference point as the purchase date and price, and remember to consider both price and duration of ownership when calculating your returns. Note that I only used Fiverr as an example to illustrate this point. I am not providing any recommendation to buy or sell this stock.

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