Your emotions are getting in the way of your financial success!
It happens routinely. Stocks climb in value, and people invest too late, buying after the value is already at or near its peak. When the stock drops to a fraction of what they bought in for, they quickly sell in an attempt to minimize their loss.
What actually happened here? Those investors bought when prices were high and sold when they were low. That’s the opposite of what they should have done!
A key mistake many investors make, even some financial experts who should know better, is assuming people in an investment market always behave rationally. In fact, the opposite is often true. Studies have shown people are predictably irrational. They often make poor investment choices because they rely on emotion and unconscious biases to inform their decisions.
When you see an investment skyrocketing, you tend to get jealous. If only you owned that stock - you’d be making a fortune! But if you buy after the investment soars, you won’t make money unless it rises further. Rather than conducting due diligence to determine whether or not further increases are likely, people often buy based on what the investment has already done.
A common disclaimer you’ll see in financial advertisements and publications, including at the bottom of this one, is that “past performance is no guarantee of future results.” That disclaimer is aimed squarely at people who make decisions based on what an investment has already done rather than what it's likely to do in the future. If the investment doesn’t keep rising and instead goes down, that leads to a second common psychological investing mistake: panic.
When your investment is losing value, you naturally start getting nervous. You see that dollar figure going down and you’re tempted to sell now before you lose any more; you want that low-valued investment gone because it makes you feel unhappy.
But selling when an investment is down often leads to what we call “locked-in losses.” If the investment goes back up, you’ll have already sold at the lower value and won’t get to take advantage of the rebound. In a nutshell, you’ve bought high and sold low.
By understanding our biases, we can work to overcome them when making financial decisions. Ask yourself why you’re inclined to proceed in a certain direction. Are you selling that stock because it makes good, rational sense or because you’re panicking? I’ve compiled a list of some common biases to watch out for:
We tend to pay the most attention to information that supports our beliefs. If you think Bigfoot is real, you’ll give a lot more credence to those grainy videos than people who don’t believe. The same concept applies to finance. If you think an investment will never experience losses, you’ll tend to pay more attention to news of its value increasing and take less notice when its value drops. This can lead to unintentionally uninformed investment decisions.
Pack Mentality Bias
This happens when we tend to follow along with whatever a group of people is doing. We saw this not long ago with the “meme stock” phenomenon. Investors saw a group of people buying heavily into a few stocks and joined the crowd. But when the main instigators dumped their stock, those who followed the pack lost money. Warren Buffet once said, “Be fearful when others are greedy, and be greedy when others are fearful.” In other words, don’t blindly follow the pack!
Approach investing with an air of skepticism. Just because everyone else is doing it, doesn’t automatically mean it’s a good idea.
We tend to overestimate our own abilities and attitudes. This can lead to us thinking we’re more investment-savvy or risk-tolerant than we really are. Many are brave when the market is on fire. They then discover they’re much more risk-averse than they thought when the market takes a turn for the worse. Taking on more risk than you’re comfortable with leads to problems because you will tend to want to get rid of risky investments that are dropping in value, even if it means losing money.
Becoming a More Rational Investor
By learning to recognize our mental biases, we can understand how they influence our decision-making. Once you know you’re being pushed toward irrationality, you can take steps to make more rational decisions. At Asset Preservation Wealth & Tax, we routinely help clients overcome biases that could lead to unwise investment decisions. One huge advantage to working with a financial advisor is they will help steer you away from emotional decisions. They can help you create an investment strategy, then stick to it even when your biases are screaming at you to change course. This can not only help you make money, but avoid losing it unnecessarily as well.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.