Have you fallen into one of these common traps?
Nobel Prize recipient and renowned economist Richard Thaler revealed that, even when considering decisions that inherently benefit us, we often get it wrong. Our brains don’t want to process information like robots. Instead, we combine data with emotion; mix logic with intuition; see patterns where none exist; and overwhelm ourselves with so much data that we may not make a decision at all.
Sound familiar? It should. Because we can practically guarantee that you – and everyone you know – have fallen into one of these traps.
Overconfidence: “Nothing can go wrong”
(Mis)behavior: Most of us think we’re smarter than the average bear, which can lead to taking greater risks than we can really handle. Being too confident also can lead to miscalculating the probabilities of good and bad outcomes, overweighting an investment’s potential upside and discounting the potential downside.
Better behavior: Push pride aside, and remember that no investment can sustain upward momentum forever. When you feel strongly about an investment or strategy, seek counterarguments and listen objectively.
Information Overload: “It doesn’t matter”
(Mis)behavior: Who among us hasn’t been overwhelmed by the vast array of information available at our fingertips? Information fatigue can leave you unable to make a decision, or perhaps worse, leaping to errant conclusions.
Better behavior: At a certain point, more information – particularly when it’s presented by the media as “breaking news” or “urgent” – only confuses things. We have control over the quality and quantity of information we receive – work with your advisor to sort out what’s relevant and ignore the rest.
Herding: “Everybody else is doing it”
(Mis)behavior: This is FOMO (fear of missing out) at its finest. As social animals, we instinctively seek acceptance from our peers, and assume that if everyone is jumping on a trend then we should, too. But in investing, following the herd may mean you’re already too late to reap the potential rewards.
Better behavior: Think for yourself. Instead of jumping on the bandwagon, do your homework to ensure the investment you’re eyeing is appropriately valued and carries the risk/reward profile you’ve outlined in your investment policy statement.
Familiarity: “I know what I’m doing”
(Mis)behavior: Some of us believe that recognizing the name of a company or having some knowledge of an industry makes our decisions about them infallible. It’s often why we find our portfolios over-weighted in a certain company, asset class or sector.
Better behavior: Don’t confuse familiarity with understanding – take a more detailed and objective look at your various options. And recognize the importance of diversification: one reason it has historically proved more successful than concentrated portfolios is because it helps reduce your exposure to company-specific risk.
Loss Aversion: “I don’t want to lock in a loss”
(Mis)behavior: Research has shown that we regret loss twice as much as we enjoy gains. This leads to tendency to hold onto losers and sell winners, or conversely, to not buy something that might decline in the short term but makes sense in the long run. For example, when rates are rising, some investors refuse to buy or hold bonds, even though they still may be needed for diversification and portfolio stability.
Better behavior: Accept that losses and gains are par for the course when investing over the long term. Let your portfolio do what it was built to do. To help manage your emotions, talk to your advisor about setting buy and sell triggers on investments within your portfolio.
Confirmation Bias: “That makes sense”
(Mis)behavior: Confirmation bias is our tendency to interpret information in a way that reflects and confirms our preconceptions – essentially, we search for green flags and ignore the red ones.
Better behavior: You may need a trusted voice of reason – like a knowledgeable investment professional – to play devil’s advocate before making a move based on your own observations. Seek out information that contradicts your existing belief and evaluate the new information as rationally as possible.
Sunk-Cost Effect: “Don’t throw good money after bad”
(Mis)behavior: This is our irrational tendency to continue with a questionable decision because we’ve already invested time, money or effort into it. For gamblers, it may be the tendency to commit even more chips to the pot after making a large initial bet, even if the odds are no longer in their favor.
Better behavior: Recognize that your initial investment – for example, four years in a job with no obvious promotion opportunities – is gone. Instead, take an objective look at whether your decision could pay off in the future. If not, it’s time to cut ties.
Mental Accounting: “But it’s play money”
(Mis)behavior: Mental accounting tricks your mind into compartmentalizing certain investments or accounts, leading you to miss the bigger picture. You might somehow exclude certain positions when you think about your overall portfolio or treat money differently depending on how you earned it. It’s how investors save money in low-yielding accounts while carrying high-interest debt, locking in a loss. This can hinder long-term investors whose entire portfolio should be working together to manage risks and make headway toward established goals.
Better behavior: Take a comprehensive look at your financial plan with your advisor to make sure it’s working toward your overall success.
Present Bias: “You only live once”
(Mis)behavior: Our brains encourage us to do what feels good now, rather than investing for later. Instant gratification overshadows our long-term intentions.
Better behavior: Put your inner procrastinator in check and use your advisor to help you invest, save and spend rationally so you can balance your current wants and needs with your mid- and long-term goals.
Behavioral finance doesn’t ask that we change our basic human nature, only that we understand our individual tendencies or biases and learn how to adjust for them when making investment decisions. It won’t always be easy, so it helps to have a trusted advisor who can bring experience and perspective to the table.
Sources: 361 Capital; B2B International; Business Insider; Bloomberg Businessweek; investopedia.com; Franklin Templeton