Do you feel the pain of loss more than the joy of gains? How to separate emotions from investing.
It’s not unusual for investors to sense a tug-of-war between their analytical brains and their emotions. Until fairly recently, investing was considered purely logical. Find the right quantitative strategy or forecasting model, and you’d be off and running.
But any investor who’s gotten the jitters and pushed the “sell” button at the first sign of a market downturn has acted on emotions. Often, the emotional response is due, at least in part, to a behavioral bias. For example, perhaps the antsy investor sat out a previous market correction, and now regrets the inaction. Or perhaps he or she just wants to feel in control, and even a panic-driven decision to sell seems better than just sitting back and doing nothing.
These days, investment advisors take seriously the behavioral components of investing, and with good reason. Even after working with a financial advisor on forming an investment strategy based on risk tolerance and objectives, investors often react in the moment or have trouble shedding long-held beliefs that may hurt their returns.
“Behaviorial Finance” is a rapidly growing area for academic research. Cognitive behavioral researchers have identified a number of common biases that affect investing. While they are not inherently bad, and most are natural to human behavior, these biases could negatively impact one’s ability to increase their financial position.
Here are eight biases that may affect investing performance:
Loss aversion. People often feel the pain of loss more than the pleasure of gains. Loss aversion takes hold when people recall investment portfolio declines more vividly than gains, sometimes even when the gains are greater. It upsets people if they lose money when the market goes down. People remember losses forever, but they don’t remember the years they made 30 percent – just years they lost 20 percent. It’s critical that investors have discussions with their advisors about market expectations and managing emotions during downturns.
Confirmation bias. People are often drawn to information or ideas that validate existing beliefs and opinions. For example, many TV viewers prefer a news channel that represents their own political views, avoiding those featuring commentators of different opinions.
It’s no different when it comes to financial topics. An investor may have a belief about market conditions and gravitate toward and seek out information sources that confirm that belief.
Confirmation bias often happens when we attach an emphasis to the outcomes we desire, such as investing too much in the stock of the company you work for, which also reduces your diversification. The best way to overcome this bias is to consider information from multiple sources – and seek out different opinions and views.
Anchoring. Anchoring refers to the tendency we have to attach (or “anchor”) our thoughts to a reference point – even though it may have no logical relevance to the decision at hand.
One very common example of “anchoring” is the usage of an investors purchase price as the anchor when making future decisions. For example, let’s say an investor purchased an investment for $40, but the company’s financial situation recently negatively changed and the stock is now trading at $20/share. Waiting to sell the investment until it reaches the $40 price target would be “anchoring”.
Mental accounting. First identified by behavioral economist Richard Thaler of the University of Chicago, mental accounting occurs when a person views various sources of money as being different from others.
Mental accounting can manifest itself in a few ways. Money earned at a job may be viewed differently than money from an inheritance. This can affect the way the money is spent or invested.
It’s fairly common for investors to be emotionally tied to certain stocks. Two of the most common examples I see of this is with inherited stocks/investments and with company stock, of either current or previous employers.
Illusion of control bias. After a prominent plane or train crash, it’s not hard to find online commenters proclaiming a preference for travel by car, saying they feel more in control when driving. Many are resolute in this preference despite decades of research showing that air and rail are statistically much safer.
A similar thought process applies to some people’s investing decisions. The illusion of control begins with the word ‘should,’ as in, ‘I should be able to pick the right stocks,’ or ‘someone should have the ability to time the market to achieve superior results consistently’.
People can easily justify those ideas, but that thought process can be financially damaging. People who live under this belief have trouble coming to terms with the irrationality and variability of markets and the impossibility of their expectation. The outcome is typically a spiral of financial disaster and the rationalization that while their belief is correct, the person who pushes the buttons wasn’t competent.
Recency bias. When gas prices fall, sales of large sport-utility vehicles and trucks tend to rise. It’s not difficult to see the connection: Consumers believe what’s happened recently will continue to happen.
The phenomenon also exists with investing. It’s no secret that investors tend to chase investment performance, often piling into an asset class just as it is peaking and about to reverse lower. Because the investment has been climbing higher recently, investors believe that will remain the case.
Unfortunately, research has shown that it’s essentially impossible to predict which asset class, sector or geographic region will be the top performer in any given year. But past performance – in particular, recent past performance – can be a strong driver, as few people want to feel left behind.
Hindsight bias. “I knew that would happen.” Who hasn’t said or heard that, probably many times? While the know-it-all who reminds people of his or her forecasting prowess can be annoying, hindsight bias can have detrimental effects on one’s finances.
Humans tend to overestimate the accuracy of their predictions. This can be costly as we get a false sense security when making investment decisions, which can lead to excessive risk-taking behavior and place people’s portfolios at risk.
Herd mentality. Humans are social animals, and marketers have become adept at creating social proof that since other buyers like their products, so should you. It’s another type of thought process that takes hold when a person doesn’t want to be left out of a trend or a movement (aka “FOMO – or Fear Of Missing Out”).
That’s very true when it comes to investing. Just because the larger herd is stampeding into or out of a stock, sector or region, it doesn’t mean that’s the right move for an investor with his or her own objectives.
Investors that buy when the market is high and sell when the market is down are more than likely influenced by the herd mentality. This bias occurs when individuals are influenced by their peers to follow trends, purchase items and adopt certain behaviors, even if it is not in their best interest. It is important to stop and ask yourself why you are making this financial decision, and looking to see if it aligns with your financial plan. Doing so will go a long way in helping ensure that the actions you are taking are actually right for you, not for someone else.
Paul Staib | Certified Financial Planner (CFP®), MBA, RICP®
Paul Staib, Certified Financial Planner (CFP®), RICP®, is an independent Fee-Only financial planner. Staib Financial Planning, LLC provides comprehensive financial planning, retirement planning, and investment management services to help clients in all financial situations achieve their personal financial goals. Staib Financial Planning, LLC serves clients as a fiduciary and never earns a commission of any kind. Our offices are located in the south Denver metro area, enabling us to conveniently serve clients in Highlands Ranch, Littleton, Lone Tree, Aurora, Parker, Denver Tech Center, Centennial, Castle Pines and surrounding communities.
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