5 Biases that Investors Should Avoid
Volatility in the stock market can make it difficult for an individual investor to know what to do. Instincts often send one signal and the brain another. Even worse, the very best investment decisions often feel wrong in the moment. Buying during a market downturn, holding a long-term winner in the face of a short-term loss, or trimming a winning position when it grows too large rarely feel like the right things to do.
While investment performance predictions are based on the idea of a "rational investor" – one who makes decisions that result in the optimal level of benefit for the individual – in practice most individuals and professionals suffer from one of several Behavioral Finance biases.
Behavioral Finance is the intersection of traditional finance and psychology, identifying and navigating the differences between what investors should do and what they actually do.
According to an article from Russell Investments, there are over two hundred identified biases that impact money decisions. Here are five of the most common – and important – for investors to identify and address.
• Loss Aversion – People tend to prefer avoiding loss more than the gratification of gain. Psychology Today estimates that we feel loss about twice as much as gain, so that even a 50-50 chance of success may seem too risky. This fear of loss may cause investors to sell winning securities too early, while simultaneously causing them to hold losing positions too long.
• Over-Confidence – Investors can over-estimate or exaggerate their ability and expertise, believing they are experts when they are not. An article from Charles Schwab claims that high-performers – like doctors, lawyers, and others working in complex environments – have been shown to exhibit over-confidence when it comes to investment decisions. Believing they can time the market, for example, may lead them to trade too much or too often, while over-confidence in the ability to spot opportunities may risk too much exposure on a perceived hot stock.
• Herding – People tend to mimic the actions of the larger group. When the herd sells, individual investors tend to join in – even when it means selling low. When the herd buys, people tend to jump on the bandwagon – even when it means buying high.
• Familiarity – Humans generally prefer what is familiar or well-known. This is evident in the way investors tend to overweight their portfolios toward favorite industries or home countries, despite best practices of diversifying among & within asset classes and across national borders.
• Mental Accounting – Investors often attach different values to money based on its source or its use. An additional $10 on the price of a new car feels like a drop in the bucket, but an additional $10 for a tank of gasoline feels like a lot. When it comes to investing, mental accounting can put investors at serious risk, and may cause them to avoid proven techniques such as Monte Carlo simulations, multi-asset investing, or diversification.
A good philosophy is to always – in good markets and bad – have some portion of monthly income going to consistent investments (such as the same amount in the same fund or ETF in the same account every month). A simple, actionable, and repeatable investing practice will improve the odds of success over years and decades.
Iseler Financial, LLC | Registered Investment Advisor | Durham NC
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