Many people view investing as an analytical exercise. Reviewing past investment returns, calculating percentages and crunching numbers are part of the process. However, the emotional and behavioral aspects of investing are arguably more important.
Investors often let their emotions or human nature lead them to poor decisions, costing them substantial returns over time. I see this firsthand as a financial adviser. Part of of my job is helping clients manage their fear and greed to help avoid making poor investment decisions.
Multiple industry studies by firms such as Vanguard and Dalbar Inc. have shown that investors consistently under-perform the broader markets due to poor decision-making that is often based on emotion. Depending on the study and time frame reviewed, this under-performance can be as much as 4% per year.
Human beings are wired to make decisions quickly and depend on past experiences to inform action. These tendencies can serve us well at times, but they can get in the way when managing investments. This often expresses itself in the form of behavioral biases. We all suffer from these biases in some form or another.
Here are some common ones that can be troublesome for investors.
▪ Fear of missing out: Have you ever had a conversation with a friend or family member who was bragging about how much money they made in a particular investment and it makes you anxious or uncomfortable? This is likely fear of missing out taking hold. This anxiety about missing out on a hot investment can lead to making a rash or poor investment decision.
▪ Recency bias: People tend to remember recent events more easily than things that happened in the more distant past. As a result, we tend to use recent events as a guide to what we think will happen in the future. With investing, if stocks are down, people tend to think they will continue to go lower and become scared to invest. Conversely, if stocks have been on a roll, people are naturally inclined to think they will keep going up and may take too much risk. If you use recent history to inform your investment decision, it could lead to making a mistake.
▪ Confirmation bias: This is a human tendency to seek out information that reinforces existing beliefs and to discount or disregard information that contradicts our beliefs. We see this in many areas of life, from politics to parenting. When it comes to investing, if you believe a certain stock or strategy may be profitable, you will tend to seek out information that supports that belief. The reality is that focusing on contrary opinions or potential flaws in the strategy would likely be more helpful in making a profitable investment decision.
▪ Anchoring: This is when a person uses irrelevant information to help make an investment decision. This is often in the form of using a historical price of an investment as an indicator of current or future value. For example, consider a situation where an investor purchased a stock for $50/share and it went up to $100 per share, then retreated to $70/share. An investor might not be willing to sell the stock until it gets back up to $100/share. This historical price level is irrelevant to the current or future price of the stock. Focusing on this historical high-point can cause an investor to hang on when they should look to sell.
▪ Over-confidence: People tend to overestimate how good they are in terms of skill or performance. If one believes he is better or smarter than he really is, it can lead to poor investment decisions, such as trying to time the market or take on too much risk.
There is an old saying that “knowledge is power.” Being aware of and understanding our behavioral biases can give us the power to overcome them. This can help us make better investment decisions by avoiding pitfalls like recency bias and overconfidence.
Before investing some of your hard-earned money, consider how you arrived at the decision and check for signs of these behavioral pitfalls. If you struggle to see them, consider working with an adviser who can help you understand these tendencies and avoid the human instincts that can lead you to poor decisions.
Lucas Bucl is a CERTIFIED FINANCIAL PLANNER professional and a principal at Aspyre Wealth Partners in Overland Park. He helps clients define what success means to them and then build a plan to achieve it.