As humans, our instincts propel us to pile into things when they are going great and run from them when they are not. This is the exact opposite of what should be done in investing.
Yet, we see the same misguided behavior over and over again…
A small piece of your portfolio increases by 200%. This gets you excited, so you want to sell off part of your well-designed (and well-diversified) portfolio to buy more of the expensive, high-performing asset in anticipation of the run continuing. Even though price and value are inversely correlated, human nature still lures you to the momentum of price increases. When you buy a stock, you are paying for earnings. Hence, the higher price you pay for those earnings, the less value you receive.
Then the opposite happens.
The market declines by 35%. Even though you’ve experienced decline and recovery multiple times in your lifetime, you still want to sell the most heavily affected bits of your portfolio and hide out in cash “until it blows over.” This perfectly reflects March and April of 2020.
Now, because U.S. stocks have outperformed for a decade, people want to sell all their international holdings and their smaller companies and pile into that index. Even more dangerously… they want to concentrate on a couple of outperforming U.S. stocks.
Behavioral finance is a relatively recent discipline that acknowledges the fact that humans are not rational. Traditionally, the humans in economics textbooks were presumed to be rational, unbiased, optimization-seeking decision-makers. In reality, we act on emotion, make irrational decisions without full information, and think illogically.
Behavioral finance recognizes this and teaches us about all the personal finance mistakes we are prone to make. Today we are going to talk about five common behavioral mistakes in investing, so you can know what to avoid.
Overconfident investors often believe: 1) that it is possible to predict markets, and 2) that they know how it is done. In a survey of professional investors 74% responded that they were above average. The other 26%… just average. No one claims to be below average.
Several studies show that overconfident investors make more trades in an effort to align their positions with current markets. The cost of these frequent trades adds up, creates taxable gains, eats into profit, and rarely brings additional return. When the overconfident investor doesn’t see the expected results, he makes even more trades: a cat chasing its eluding tail.
2. Confirmation bias
As I have mentioned, we like to think that we gather all the appropriate information we need before we act. Confirmation bias is our tendency to seek out information that supports our previously held ideas and beliefs and ignore information that contradicts it. We form our opinions first, then seek out validation.
3. Mental accounting bias
Mental accounting occurs when you treat money differently depending on where it came from and how you will use it. You earmark tax refunds as fun money, but a regular reimbursement from your work trip may go toward the bills.
In investing, this means you’re more likely to risk gains than principal. You view gains as extra money the market’s made for you. But the principal is your hard-earned dollars.
Mental accounting is challenging because it turns your attention away from your overall wealth. Instead of focusing on your net worth, you focus on how your 401(k) is performing. Your portfolio SHOULD BE made up of things that perform differently – this is what “diversification” is all about.
4. Anchoring bias
Anchoring bias happens when you allow dated, (possibly) irrelevant information to inform a decision.
Let us say you’ve been researching a stock that’s selling for $50 a share. You have decided that it’s a good buy at $45. Suddenly, the price jumps up to $80. You missed your shot. Some days later, you check, and the stock is back down to $50. You now think you can get it at a good price, so you snatch up a share for $50.
This is an example of anchoring. The price is back at $50, the same as it was a few days ago and still above your target price, but now your mind is anchored on the $80 price tag, so you think you have bought at a bargain price.
Any price is just the price. Anchoring changes your perception of the price, but it doesn’t change the value. Be careful, anchoring can sometimes play a big part in purchase decisions.
5. Loss aversion bias
Nobel prize winning psychologist and economist Daniel Kahneman found that people feel the pain of a loss twice as much as they feel the pleasure of a similar gain. When you experience a win, your happiness increases for a little while. When you experience a loss, the pain sticks around a lot longer.
Investors with a loss aversion bias tend to monitor portfolios constantly for losses and gains. As soon as something goes south, they feel a twinge in their stomach telling them to run to safety.
If you’re investing money you won’t need for 10 or 15 years, as long as you have properly asset-allocated, broadly diversified and rebalanced, it shouldn’t matter how it’s performing right now.
How to combat behavioral mistakes
The real challenge when investing is sticking with it when it isn’t working. Emotional cycles are much shorter than market cycles. Realize there are inherent risks in any kind of investing. No matter what process you follow, it will work well in some instances and will work less well in others. This is why bias is a problem — it moves you to make changes when you shouldn’t.
While it is human nature to run toward things that are overperforming and run away from things that are underperforming, this strategy will prevent you from accomplishing your long-term plan — and you should have one. Be aware of your own behavioral biases in investing, so you can stand firm when human nature kicks in.
Jonathan K. DeYoe is President of DeYoe Wealth Management, Inc dba Mindful Money, a Registered Investment Advisor. He is the author ‘Mindful Money: Simple Practices for Reaching Your Financial Goals and Increasing Your Happiness Dividend.’You can follow Jonathan at mindful.money; on YouTube; on LinkedIn; on Facebook; on Instagram; and on Twitter.This material is solely for informational purposes. Advisory services are only offered to clients or prospective clients where DeYoe Wealth Management, Inc. dba Mindful Money and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by DeYoe Wealth Management, Inc. dba Mindful Money unless a client service agreement is in place. Mindful Money is a service mark of DeYoe Wealth Management, Inc. a Registered Investment Adviser.