5 common behavioral finance traps
Understanding both the “how” and the “why” of irrational behavior can be invaluable to investors.
Research shows that many individuals are overconfident, under-diversified, short-sighted and often swayed by the media.
Learn how to protect yourself from your basic instincts.
Imagine world full of “rational” people who could maximize their wealth while minimizing risk. The ratings would be terrible for every cable-TV money show and there would be a lot fewer financial advisors in business. Rational individuals would assess their risk tolerance honestly and then determine an investment portfolio that met their income needs within their risk comfort zone. However, we know that most individuals are NOT capable of being rational—research has proven this time and time again.
Behavioral finance encompasses a body of theoretical and empirical academic research that seeks to explain how and why people, especially investors, do not act in a rational manner.
First let’s look at how investors behave irrationally:
Their portfolios are not sufficiently diversified.
They trade actively with high turnover and high transaction costs.
Too much of their wealth is tied up in their employer’s stock or in their own company’s stock if they’re a business owner.
They’re over-concentrated in or stocks of companies within their own industry or their immediate geographic area.
They tend to buy, rather than sell, companies that are mentioned positively in the news.
They tend to sell their winning investments while holding onto their losing investments far too long in a futile chase back to “break-even.”
Now let’s look at five common reasons why individuals behave so irrationally:
1) Recency bias. We tend to make our decisions—especially financial ones—based on what happened to us most recently. Suppose a stock we just unloaded zoomed up by 50 percent a week after we sold it. Ouch! Then suppose there’s an earnings miss on another stock we’re holding, even though our disciplines might tell us to sell it. We’re scared to death that the same timing mistake we just made will happen again – i.e. the stock will zoom back up right after we sell it.
2) Anchoring. In one sense it’s about having a mental stake in the ground to give you a framework for making decisions. For example, news about new market highs is blaring every day (Dow 26,000! S&P 2,800!). And people are saying to themselves: “New highs! New highs! It must be time to sell.” But think about it. New highs are usually a positive sign for the market. We get anchored into these numbers and they distort our thought process. As a general rule, introverted people tend to be more skeptical. And that mindset can really hurt us in our investing because you miss out on opportunities or give up on an investment too quickly. On the flip side, extroverted people tend to be optimistic most of the time, but that can also hurt you as an investor, because you tend to expose yourself to too much risk—again and again.
3) Mental accounting/fallacy of breakeven. Picking winners is not the big problem for most investors (do-it-yourselfers and many pros). The problem is that they can’t let go of their losers. When you’re holding on to your losers, your ego gets in the way. You tell yourself: “I’m know I’m right about this stock, the market just hasn’t recognized its value yet.” Or, you tell yourself, “I did so much work analyzing this stock, I can’t bail on it now.” So, you start doing all kinds of mental accounting and then at the end you tell yourself that you’ll sell the stock just as soon as it gets back to breakeven. And that’s an ABSOLUTE KILLER in investing.
When you hold on to a losing investment for too long trying to get back to break even there’s an opportunity cost. All those months and years that your money is tied up waiting to get back to breakeven means it can’t be deployed elsewhere in a more profitable investment.
4) Confirmation bias. Let’s say you have a great investment thesis, but you want it confirmed before you pull the trigger on it. So, you run around trying to get confirmation bias from all your smart friends, your broker and the Wall Street pundits whose picks you typically like. Unfortunately, you’ve got a self-selected group of people who generally share your world view. If you’re honest with yourself, you’ll see they’re wrong more often than right.
Confirmation bias illustrates the danger of following the news media all day long and the danger of blindly following managers who have had the “halo effect” (i.e. hot hand) for the past several years. So you dive in and start following them and it often doesn’t work out. Remember those elite gurus who predicted that the housing crisis 10 years ago would trigger the global financial crisis. They made a fortune! So many investors piled into their funds waiting for them to work their magic again—and a decade later they’re still waiting.
5) Gambler’s fallacy. This occurs when you believe a purely random event is really NOT really random and that it’s going to continue to happen into the future. You start loading up now on FAANG stocks (Facebook, Apple, Amazon, Netflix, Google) because you think they’re going to stay hot forever. You predict the next coin flip is going to land heads because the last 20 flips also landed heads. In reality, you have no way of knowing which side is going to land facing up. It’s completely random, just like so much of investing is. Most of the time, we have no control over what’s going to happen in the market. This fallacy that you actually have control due to some event that is random that you think is NOT random.
Behavioral finance literature serves as a reminder why it so important to protect yourself from you basic instincts—especially when markets are volatile. Safeguarding your wealth is a responsibility, not just to yourself, but to your family and the causes you support. Don’t hesitate to contact me if you suspect that you, or someone close to you, might be drifting from your long-term financial plan.
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail email@example.com.
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