Ignorance definitely isn’t bliss when it comes to your investments, and yet we all seem to be hard-wired with blind spots, or as psychologists call them, behavioral biases. Here are some of the more common ways we tend to make irrational and unprofitable investment decisions.
1. Assigning too much value to the most recent news
Try to remember what you had for dinner on each of the past seven nights. Assuming there was nothing unusual about any of the meals, which one do you think you’ll remember most easily? Last night’s dinner, right?
That makes sense. It’s only natural that we would remember most clearly what happened in the most recent past.
But here’s the problem when it comes to investing: It isn’t just that we most easily remember what happened in the recent past; we tend to assign greater significance to the most recent events as well, viewing them as indicators of what’s likely to happen in the future. That’s called recency bias.
For example, let’s say you’re thinking about buying a particular stock. Before placing a buy order, you check its performance today and are pleased to see that it’s up. Without consciously thinking about it, your built-in recency bias sees this as added confirmation that the stock is worth buying. It might be a good stock to buy, and it might not. One day’s performance means very little.
What to do? Make sure you’re basing your investment decisions on something more than just the most recent news. You need a comprehensive process for deciding what investments to make. (Read Is There a Trustworthy Process Behind Your Investment Strategy?)
2. Reacting too strongly to bad news
Recency bias can be magnified if the recent news is bad, and of course, there’s been plenty of bad news lately. This is called loss aversion — the tendency to feel the pain of loss on a much greater magnitude than the pleasure of an equal gain. According to some studies, losses can feel twice as bad as the good feelings that accompany comparable gains.
Loss aversion can lead to many forms of bad investor behavior. During a steep market decline, some investors can’t stomach the pain and decide to sell. But that often makes matters worse because selling locks in their loss. When the market eventually cycles back up, fear keeps them on the sidelines and they miss the rebound.
How to combat loss aversion? Don’t monitor your portfolio so closely. People who check their holdings frequently have been found to trade more (because of fear-based selling) and generate lower returns than those who monitor their portfolios less often.
3. Seeing only what you want to see
As the old saying goes, if you’re a hammer, everything looks like a nail. By the same token, if you have a hunch about a particular investment, and especially if you’ve become emotionally attached to the idea of owning it, you may tend to notice only news that supports your point of view.
When confirmation bias gets its claws in you, it becomes very difficult to see things differently. You will ignore contradictory information, selectively remember conversations or articles about the investment you are considering, and even read ambiguous commentary as favoring your point of view.
Confirmation bias goes a long way toward explaining the existence of “perma-bears” and “perma-bulls” — market analysts who always see a bear or bull market on the horizon and can point to evidence supporting their opinions.
To avoid confirmation bias, proactively seek opposing points of view. Feeling strongly attached to the idea of investing in XYZ Corp? Look for reasons not to invest in it.
4. Using the wrong benchmarks
When you walk into a car dealer’s showroom and see one of its most expensive vehicles on display, the model you had in mind probably looks like a bargain. That’s a type of bias called anchoring in action, with the expensive car serving as a very influential point of reference.
When it comes to investing, it’s common for people to anchor their portfolio’s performance to “the market.” Even if they have 40 percent of their money invested in bonds, the fact that the market generated a 30 percent gain makes them feel bad about their paltry 18 percent. It might even prompt them to change their portfolio and take on more risk than they should.
What’s the solution? Create a written investment plan tailored to your age and risk tolerance, including a realistic assumed average annual rate of return, such as 7 percent. Using that as your anchor, an 18 percent return wouldn’t be a disappointment; it would be amazing.
Other ways to combat behavioral biases
The ideal emotional state for an investor is unemotional. However, we’re not robots. So, awareness of our many biases is a good starting point for preventing them from steering us in the wrong direction.
Another helpful step is to press the pause button. Since it’s impossible to time the market, waiting a couple of days before executing a buy or sell order isn’t going to make much difference in that investment’s performance. However, using that time to question your assumptions may make a big difference in helping you more rationally decide whether the investment should be bought or sold in the first place.
By far, the single best step you can take toward unbiased decision-making with your investments is to use an investment strategy that’s fueled by an objective investment selection process.
Take it to heart: “The heart is deceitful above all things and beyond cure. Who can understand it?” – Jeremiah 17:9
Take action: To put an unbiased investment process to work in your life, read, and act on, 6 Principles for a Solid Investing Plan.
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