Mental mistakes that can cost you real money
For decades behavioral finance was largely an academic pursuit, more recently this body of knowledge has been recognized for its impact on investing. Daniel Kahneman and Richard Thaler have been awarded Nobel Prizes for their contribution to this field of research. What follows is behavioral finance in plain English. Knowing these mental blind spots might make you a better investor.
Legendary economist and investor Benjamin Graham said it best “The investor’s chief problem – and even his worst enemy – is likely to be himself.”
Your own behavioral biases are often the greatest threat to your financial well-being. As investors, we leap before we look. We stay when we should go. We cringe at the very risks that are expected to generate our greatest rewards.
Most of the behavioral biases that influence your investment decisions come from mental shortcuts we depend on to think more efficiently and act more effectively in our busy lives. Usually these short-cuts work well for us. They can be powerful allies when we encounter physical threats, or even when we’re simply trying to stay afloat in the sea of decisions we face every day. These same survival-driven instincts that are otherwise so helpful can turn problematic in investing.
Let’s take a look at these concepts…
Anchoring: Going Down With the Ship. Fixing on earlier references that don’t serve your best interests.
Real life scenario: I paid $11/share for this stock and now it’s only worth $9. I won’t sell it until I’ve broken even.
Confirmation: The “I Thought So” Bias. Seeking news that supports your beliefs and ignoring conflicting evidence.
Real life scenario: After forming initial reactions, we’ll ignore new facts and find false affirmations to justify our chosen course … even if it would be in our best financial interest to consider a change.
Familiarity Breeds Complacency. “Familiar” doesn’t always mean “safer” or “better.”
Real life scenario: By over concentrating in familiar assets, you decrease global diversification and increase your exposure to unnecessary market risks. This is very common when employees own a large stake in their employer’s stock.
Fear: “Get Me Out NOW!”. The panic we feel whenever the markets encounter a rough patch.
Real life scenario: While you may be well-served to run from a dangerous physical situation, doing the same with your investments might lock you into a loss without participating in the recovery.
Greed: Excitement Is an Investor’s Enemy. Fear of missing out, Chasing hot stocks, sectors, or markets, hoping to score larger-than-life returns.
Real life scenario: When you speculate, you can get burned in high-flying markets. Remember to focus on what really counts: managing risks, controlling costs, and sticking to the plan.
Loss Aversion: Avoiding Pain Is Even Better Than a Gain. We are hardwired to despise losing even more than we crave winning.
Real life scenario: We attempt to time the market by selling before it drops. Ultimately, market-timing is more likely to increase costs and decrease expected returns.
Overconfidence: Better Than Average? Everyone believes they’re above average. Clearly, not everyone can be correct.
Real life scenario: Overconfidence makes you believe you’ve got the rare luck or skill required to consistently “beat” the market, instead of patiently participating in its long-term returns. Slow and steady wins the race.
Sunk Cost: Throwing Good Money After Bad. It’s more painful to lose something if you’ve already invested time, energy, or money into it.
Real life scenario: The past is past. Don’t let sunk cost fallacy stop you from unloading an existing holding once it no longer belongs in your portfolio.
Don’t go it alone – your brain has a difficult time “seeing” its own biases. Having an objective advisor dedicated to serving your highest financial interests is among your strongest defense against all of these mental traps.