Five Behavioral Finance Biases for Individual Investors (from Russell Investments)
From Russell Investments*, a little something to mull over when thinking about investing and the volatility of the market. Hope it helps to steady your nerves about the recent (and likely upcoming) choppiness in the markets.
Five Common Investment Biases
Within the science of behavioral economics, there are over two hundred identified biases that impact money decisions. Here are the five we consider to be the most common—and the most important for advisors to address.
• Loss aversion – Humans tend to prefer avoiding losses more than acquiring equivalent gains. In other words, the pain of loss is a more powerful force than the gratification of gain. This fear of loss may cause your clients to want to sell winning securities too early. And the fear of missing out may cause investors to hold onto losing securities too long.
• Over-confidence – Investors tend to over-estimate or exaggerate their ability and expertise. In other words, they tend to believe they are experts when they are not. Their belief in their ability to time the market, for example, may cause them to trade too often or at the precisely wrong time. Or their belief in their ability to identify opportunities may cause them to risk too much exposure on a perceived hot stock.
• Herding – Humans tend to mimic the actions of the larger group. When the herd tends to sell and pull out of the market, individual investors tend to join in, even if it means selling low. When humans tend to buy, individuals tend to jump on the bandwagon, even if it means buying high.
• Familiarity – Humans tend to prefer what is familiar or well-known. We see this in the way investors tend to overweight their portfolios toward their home countries, even when there might be a recommendation to diversify globally.
• Mental accounting – Investors tend to attach different values to money based on its source or its use. Think about how an additional $5 for rent feels like a little, but an additional $5 spent on groceries feels like a lot. Or, sometimes investors may take an unnecessary loan from a bank to avoid dipping into savings, even if it means losing money. When it comes to investing, mental accounting may put investors at serious risk, and can cause them to avoid proven, sophisticated tools such as Monte Carlo simulations, multi-asset investing, or even basic diversification.
My personal philosophy is to always have some part of your income going to regular and consistent investing (such as the same amount in the same investment in the same account every month) and, if you are able to afford it, having a little cash on the side to use for when the market does take a dip. Instead of pulling out because the market lost, say, 10% in a week, look at it as an opportunity to buy the thing you would buy anyway but at 10% off (or 20%, or 30%, etc.).
For anyone new to investing – the impeachment process is almost certain to increase volatility in the markets (institutional investors do not like political instability) and you *may* have the opportunity to start investing during a market downturn (which would substantially increase your returns when the market recovers). Something to keep in mind.
* Timothy Iseler and Iseler Financial, LLC, have no business relationship or beneficial agreement with Russell Investments.