Investors often incorrectly make judgments based on personal beliefs, past events and preferences. These biases lead them away from rational, long-term thinking while focusing on only one aspect of a complex problem, often to the detriment of their financial success.
“Typical investor behavior is irrational,” says Shawn Ballinger, a wealth manager at Budros, Ruhlin & Roe, Inc. “They’re often chasing performance based on recent investment trends with little thought to due diligence.”
Smart Business spoke with Ballinger about the more common biases and how they hurt an investor’s chances of making financially successful investment decisions.
What are the more common cognitive and emotional biases that lead investors to make investing mistakes?
There are many biases that have been identified in the modern study of behavioral finance. Among them is availability bias, which sees people tend to weight their decisions toward more recent information. This is especially problematic for today’s investors with 24-hour coverage of the global financial markets.
Anchoring and loss aversion biases, which typically coincide with each other, are the tendencies for investors to hold on to losing stocks for too long in an attempt to break even, and sell winning stocks too soon. These investors are willing to assume a higher level of risk in order to avoid the negativity of a prospective loss because losses hurt more than gains feel good.
Familiarity or home bias is the tendency for investors to invest in what they believe they know best. An example would be a corporate executive whose net worth is almost exclusively tied to the stock price of his or her corporation. Of course, this was to the detriment of many bank executives during the Great Recession who held a lot of their corporation’s common stock and ultimately suffered huge losses.
With hindsight bias, a person believes, after the fact, that the onset of an event was foreseeably obvious when it could not have been reasonably predicted. A great example of this is the high valuations of technology stocks in late ’90s. Only after the tech bubble burst in early 2000 did it seem logical that stock prices were extremely overvalued.
What are considered to be the two primary classes of investors?
Most investors can be categorized as either ‘overconfident’ or ‘status quo.’
Overconfident investors trade frequently while status quo investors leave their portfolios largely unmanaged. This doesn’t mean that the status quo investor is taking less risk. Either type of investor can have a high-risk portfolio because of either inaction or overreaction.
Overconfident investors tend to overestimate their investment ability, often resulting in higher trading costs and undiversified portfolios.
Status quo investors fail to assess their financial condition despite potential gains from doing so.
How can investors increase the probability of a successful investment outcome?
Investors should stay focused on their long-term planning goals and steer clear of herd behavior or the latest investment trend.
Additionally, they should maintain an adequate liquid cash reserve for living expenses. Knowing that you don’t have to react to today’s market headline to meet your everyday needs will help keep your emotions in check and increase the probability of a successful, long-term investment outcome.
Who can help ensure investors are pursuing a sound investment strategy?
If you can’t control your emotions and don’t have the time or necessary skill to manage your investments, consider working with a fee-only adviser, ideally a CFP®, to formulate a written investment policy statement. This can prevent investors from making irrational decisions during times of economic stress or euphoria. Selecting an asset allocation strategy that is suited to your need, ability and willingness to take risk will help you weather turbulent markets. Review your portfolio annually for appropriateness and identify where adjustments need to be made due to relative performance.
While behavioral biases cannot be completely eliminated, recognizing them is the first step in reducing their effects and avoiding self-destructive behavior.
Insights Wealth Management is brought to you by Budros, Ruhlin & Roe, Inc.