When it comes to money, it’s easy to let your emotions get the best of you, especially during times of personal stress or market volatility. Even experienced investors should avoid making financial decisions based on emotions rather than facts.
Here are four common investing biases that can cloud your judgment. Keeping these trends in mind can help you avoid making regrettable decisions with your hard-earned money.
Overconfidence means that investors tend to overestimate their ability to earn returns and underestimate the risk associated with a particular investment. For example, imagine you are an investor who has recently had success picking winning stocks. You may conclude that success depends solely on your investment skill. This may be the case, but it is also possible that the results are due to market forces beyond your control. The problem is that in both cases, recent success may encourage you to take bigger risks. Although this may lead to larger profits, it is also likely to lead to larger losses.
Herd mentality, which is investors’ tendency to follow and copy what other investors are doing, also tends to distort short-term risks in up markets. Therefore, investors may mistakenly ignore volatility and the possibility of loss in pursuit of higher returns. Investors are best served by following objective information and forming the expectation that stocks will not move in a straight line.
Loss aversion is innate. It is said that we feel the pain of a loss twice as strongly as the joy of a gain. In order to minimize the pain associated with investment loss, investors may be more inclined to take actions that could derail their long-term investment success. During market declines, investors can react quickly by selling stocks and over-allocating to bonds or cash to prevent further losses and protect their holdings. Many investors sold their stock funds for bond funds and cash during the 2008/2009 financial crisis. Unfortunately, by doing this, they missed out on subsequent rallies that eventually occurred and helped send stocks to new highs.
While it may be tempting to step aside during times of market stress, investors may want to avoid over-allocating to cash and locking in investment losses that they otherwise cannot incorporate into normal portfolio management activities. More importantly, if you maintain a well-diversified investment mix and own high-quality stocks and bonds, you can better absorb short-term investment losses and weather eventual market cycles that come and go over time.
Anchoring means that investors tend to rely too much on certain information or current conditions to make decisions. Our minds can “fix” on information and use it as a reference point to move forward, regardless of its relevance. For example, investors may hold on to weak investments by expecting them to break even at the price at which they were purchased. If you’re trying to decide whether to sell or hold a stock, are you basing your decision on what you know about the company and the state of the market? Or do you base your target price on the purchase price or other metrics that may be less relevant to the stock’s future path?
To help combat such biases, it is important for investors to recognize that market conditions change routinely and sometimes suddenly. Therefore, your perspective may need to change accordingly. Investors can adapt to new market developments by seeking objective information, relying on a financial advisor for sound advice, and setting realistic assumptions for potential returns.
Pattern-seeking behavior describes our brain’s desire to look for ways to segment the flow of information and find patterns that help us quickly understand the world. Because our brains are wired to do this, investors may mistakenly believe they see patterns in market trends that turn out to be false. Since the future is sometimes unpredictable and models are not always available, investors may want to include:
• Establish realistic expectations for your portfolio in terms of both return and risk.
• Expect markets to move in unpredictable ways, especially during periods of market stress.
• Although unpredictable in the near term, stocks generally move up and to the right in the long term.term.
• Society is aging and growth is slower. This means that the patterns of the past may be more difficult to apply to the future or are possibly not relevant.
Truly understanding your risk tolerance and loss threshold can go a long way in helping you stay balanced during times of market stress.
If you suspect that your personal investment biases and emotions are influencing your investment decisions, consult experts. Ask a financial professional to conduct an objective review of your portfolio, taking into account your performance and financial goals. Together, you can look for opportunities to grow your investments through disciplined investment strategies.
Bronwyn L. Martin is a Financial Advisor and Certified Financial Advisor at Martin’s Financial Advisory Group, the financial asset advisory practice of Ameriprise Financial Services LLC. Located in Kennett Square and Havre de Grace, MD. He specializes in fee-based financial planning and wealth management strategies and has been working in this field for over 23 years. To contact him: www.ameripriseadvisors.com/bronwyn.x.martin.