If you make a change to your portfolio, say you add some more money into a fund, do you check the price the next day and see if your move made money? I do, and it doesn’t make much sense.
If I have some money in a fund, I don’t check the prices every day and see if the value of my fund increased or decreased. I let the money ride with the market. But if I add $2,000 to the fund, even if I already have 10 times more in the same fund, I still prefer to see on the next day that my $2,000 move was a good one. It seems I care about the new money much more than I care about the old money, although money is just money. Money has no memory. It doesn’t know whether it’s old or new.
I don’t think I’m alone. I asked a colleague what he would do if he had 100% of his money in stock funds which lost 40%. He said he would hold because the prices are really low today. I then asked him what he would do if he had nothing in stocks but a bunch of cash in a bank savings account. He said he would buy into the market slowly because the prices may go down some more. So if he had old money in stocks, he’s willing to let it ride, but he’s not willing to do the same for his new money. So what’s so special about new money that makes us care more about it? When does new money turn into old money, at which point we don’t care as much about it any more?
Behavior economists call this phenomenon endowment effect. Whatever form the money is currently in, people have a preference to keep it in the same form. Therefore if it’s already in stocks, people don’t want to sell, fearing that the price is too low. If it’s in cash, people don’t want to use all the cash to buy stocks right away fearing that the price is too high. Because stocks are riskier than cash, they appear to be extra careful with their new money while they don’t mind losing their old money. It’s related to loss aversion. People are afraid of making a wrong move so they keep the money where it is, no matter where it happens to be.
How do you overcome this behavioral bias? The first step is recognizing money is just money, whether it’s old or new. Be as cautious with old money as you are with new money. Be as aggressive with new money as you are with old money. Make it mechanical. Decide on the rules ahead of the time. Write them down. When the time comes, just do it.
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commish says
mark me down as guilty.
jennydecki says
This is a great post. I’m glad I’m not the only one who feels this way about new money.
Knowing that it is a typical reaction, it will be much easier to talk myself out of illogical emotions tied to new money in the future. Before? It was an all out argument with myself that had me looking like a crazy woman LOL
calgeek says
Yes, I agree it is artificial to distinguish between old money and new money. But does this say it never makes sense to dollar cost average a lump of cash (as opposed to buying over time because you have no choice)? I often wonder if the former kind of DCA only has emotional value, i.e. you feel you got a fair price because the market is more efficient over a larger time window. What does do you think?
Harry Sit says
Dollar cost averaging makes sense if you suspect that the market is too high or if you are not sure what your ultimate asset allocation will be. So you start dipping your toe into the market while figuring out your long-term plan. Dollar cost averaging wins if the market goes down. It loses if the market goes up. But then if the market goes down, simply waiting works better than dollar cost averaging. Without a crystal ball for where the market will go, dollar cost averaging can be considered a compromise. For more on investing a lump sum all at once versus buying over time, see previous post Buy Now Or Buy Gradually Over Time?.