You think you’re smart and know yourself. As an investor, you know the rules: “buy low, sell high”, “follow the trend” or “go passive and enjoy market-matching returns.” You’ve got your strategy, and it’s working for you. After a ten-year bull market, most investors are feeling heady. You know that you’re too smart to fall for behavioral finance biases.
You might understand behavioral finance concepts that suggest that you’re acting against your own interests, but that doesn’t apply to you — or does it?
The Research Is In and You’re Wrong
Psychology, economics and finance research concur — humans aren’t as rational as we think. Rational Choice Theory, which states that humans behave rationally, has been debunked. The behavioral finance research shows how investors aren’t as rational as they think they are. We have behavioral finance biases deep into our psyches that cause us to make decisions that might not be in our best interest.
Investing behavioral biases impact all investors, professionals and amateurs alike.
Overconfidence Is Harmful
Many investors are overconfident in their ability to beat the market. Yet, you can become a millionaire in one step by circumventing overconfidence and seeking average market returns.
Investors believe that the information they accrue is great and that they’ve honed their decision-making ability to buy and sell securities at just the right time.
Research that studied active traders found that their overconfidence led to lack of diversification and over-trading. This behavioral finance bias led to subpar investment returns.
Overconfident men underperformed women investors! A Fidelity Investments survey of eight million clients found that only 9% of women believed that women would out perform men in investing. Yet, the survey found that a majority of women achieved better returns than men.
Overconfidence leads to active investment management, more frequent trading, less investment education and, ultimately, lower returns.
Thwart overconfidence by studying the financial and investment research and by trading less.
Mental Accounting Is Difficult to Conquer
All money is equal. A dividend is no different than a capital gain (except to the IRS). Yet, investors tend to segregate their dollars into arbitrary piles, to their own detriment.
Spend your dividends is a common mental accounting blunder.
There is no difference between spending your dividends or selling stock shares and spending the proceeds. In the end, you have the same amount of money.
Building up a large emergency fund, while holding high-interest rate debt is another mental accounting mistake.
That decision is just stupid. Why would you pay 15% interest on your credit card balance while saving up $10,000 in your savings account that pays 0.05% interest. You’re losing 14.95% by not paying off the credit card debt.
There are those that splurge with their IRS tax refund. In reality, that is your hard-earned cash that is not free at all, but should be treated with the same respect as the net income from your paycheck.
The takeaway is to treat all your dollars the same and make the best decisions for your overall financial worth.
Loss Aversion is the Worst
We hate to lose, significantly more than we like to win.
Amos Tversky and Daniel Kahneman discovered the loss aversion theory with a research scenario similar to this one:
Participants are offered $20 if a coin flip lands on heads. If the coin lands on tails, you give up $20.
Most people don’t accept that proposition.
Their research showed that one would need to receive roughly $40 — twice as much — on heads to be willing to pay $20 on tails.
Russell A. Podrack, professor of psychology at Stanford University found that the brain reacted more strongly in response to potential losses than to possible gains. He named that phenomenon neural loss aversion.
If you’re a perfectly rational investor and young, then you’d have most of your investment portfolio in equities because, historically, stocks returned roughly 9% annually over the past one hundred years. Yet, if you started investing at age 25 in 2008 when the stock market lost 36.55%, you might be exceptionally risk-averse.
Your recent life experience created a loss aversion behavioral finance bias.
Despite the reality that the stock market has had many more up years than down, your risk aversion could be triggered due to the 2008 market crash, causing you to invest conservatively during your entire life, losing tens of thousands of dollars or more in potential investment gains.
Another loss aversion mistake is “waiting to get even” before selling a losing investment, after the stock price tanks. Or a loss-averse individual might only invest in fixed investments, because she can’t tolerate any losses.
In most cases, loss aversion causes you to miss potential financial gain, due to your fear of losses. For many, even the recognition of this tendency is not enough to counteract it. But understanding loss aversion is a start toward conquering its ill-effects.
Don’t Shoot Yourself in the Foot
Ultimately, investing is both an art and a science. You need to understand fundamental investment principles and be aware of your personal behavioral biases. Then, use that knowledge to circumvent behavioral biases whenever possible, to maximize your investment returns. In other words, know yourself, know the markets and don’t shoot yourself in the foot.