“When it comes to investing, we have met the enemy, and it’s us.” Kiplinger Magazine
Excited by profit and terrified of loss, we let our emotions and minds trick us into making terrible investing decisions, writes Katherine Reynolds Lewis of Kiplinger Magazine.
Most individual investors allow their emotions to dictate their investment decisions. Effectively, there are two types of emotional reactions the average investor can experience:
Fear of Missing Out (FOMO). These investors will chase stocks that appear to be doing well, for fear of missing out on making money. This leads to speculation without regard for the underlying investment strategy. Investors can’t afford to get caught up in the “next big craze,” or they might be left holding valueless stocks when the craze subsides.
- Fear of Missing Out (FOMO) can lead to speculative decision-making in emerging areas that are not yet established.
- Fear of Losing Everything (FOLE) is a more powerful emotion that comes from the fear that they will lose all of their investment.
Acording to a 2021 Dalbar study of investor behavior, Dalbar found that individual fund investors consistently underperformed the market over the 20 years ending Dec. 31, 2020, generating a 5.96% average annualized return compared with 7.43% for the S&P 500 and 8.29% for the Global Equity Index 100.
“As humans, we’re wired to act opposite to our interests,” says Sunit Bhalla, a certified financial planner in Fort Collins, Colo. “We should be selling high and buying low, but our mind is telling us to buy when things are high and sell when they’re going down. It’s the classic fear-versus- greed fight we have in our brains.”
Avoiding these seven “emotional and behaviorial” investing traps will allow you to make rational investments.
- Fear of Missing Out – Like sheep, investors often take their cues from other investors and sometimes follow one another right over a market cliff. This herd mentality stems from a fear of missing out. The remedy: By the time you invest in whatever is trending, it’s too late because professional investors trade the instant that news breaks. Individual investors should buy and sell based on the fundamentals of an investment, not the hype.
- Overconfidence – Some investors tend to overestimate their abilities. They believe they know better than everyone else about what the market is going to do next, says Aradhana Kejriwal, chartered financial analyst and founder of Practical Investment Consulting in Atlanta. “We want to believe we know the future. Our brains crave certainty.” The remedy: To combat overconfidence, build in a delay before you buy or sell an investment so that the decision is made rationally.
- Living in an Echo Chamber – Overconfidence sometimes goes hand in hand with confirmation bias, which is the tendency to seek out only information that confirms our beliefs. If we think an asset holds promise for riches, news about people making money sticks in our minds more than negative news, which we tend to dismiss. The remedy: To counteract this bias, actively seek out information that contradicts your thesis.
- Loss Aversion – Our brains feel pain more strongly than they experience pleasure. As a result, we tend to act more irrationally to avoid losses than we do to pursue gains. The remedy: Stock market losses, however, are inevitable.If seeing the losses pile up in a down market is too hard for you, simply don’t look. Have faith in your long-term investing strategy, and check your portfolio less often.
- No Patience for Sitting Idly By – As humans, we’re wired for action. That compulsion to act is known as action bias, and it’s one reason individual investors can’t outperform the market — we tend to trade too often. Doing so not only incurs trading fees and commissions, which eat into returns, but more often than not, we realize losses and miss out on potential gains. The remedy: Investors need to play the long game. Resist trading just for the sake of making a decision, and just buy and hold instead.
- Gambler’s Fallacy – “This is the tendency to overweight the probability of an event because it hasn’t recently occurred,” says Vicki Bogan, associate professor at Cornell University. Over time, the probability of equities having an up year or a down year is about the same, regardless of the previous year’s performance. That’s true for individual stocks as well. The remedy: When stocks go down, don’t just assume they’ll come back up. “You should be doing some analysis to see what’s going on,” Bogan says.
- Recency Bias – Past performance is no guarantee of future results. Yet, our minds tell us something different. “Most people think what has happened recently will continue to happen,” Bhalla says. It’s why investors will plow more money into a soaring stock market, when in fact they should be selling at least some of those appreciated shares. And if markets plummet, our brains tell us to run for the exits instead of buying when share prices are down.The remedy: You can combat this impulse by creating a solid, balanced portfolio and rebalancing it every six months. That way, you sell the assets that have climbed and buy the ones that have fallen. “It forces us to act opposite to what our minds are telling us,” he says.
It is wise to always keep in mind that the market is volatile as a result of investors’ emotions and behaviors, and thus does not move logically.
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by: Katherine Reynolds Lewis – July 22, 2021