Anyone who has ever been in psychological counseling knows the mantra: Admitting you have a problem is the first step toward solving it. While it is also true that human emotions are not exactly a “problem”—they are part of being human, after all—in the world of investing, our emotions often create problems for us, if we permit them too much control over our financial decisions.
The main reason is that our emotions evolved to solve a different set of problems than those typically posed by the financial markets. Pattern recognition, adrenaline-driven reflexes, and rapid response times were crucial to our hunter-gatherer forebears; their survival depended on them. But in the financial markets, where the threats and rewards are of a completely different type, the same emotions that kept us alive on the savannah or in the forest can cost us thousands in lost profits and trading costs. Let’s look at a few of the most common behavioral traps that investors fall into.
1. Herd mentality
This one is pretty obvious. In prehistoric times, there was safety in numbers. Even today, when herding animals like caribou are threatened by predators, they put the young and the weak in the center, and the others face off the attack. But in the financial markets, the problem with sticking with the herd is that the herd is almost always in the wrong place at the wrong time. Whether it’s a stampede to buy the next “hot” stock or a panicked dash for the exits in a market downturn, following the herd will almost always be harmful to your long-term returns.
2. Recency bias
This behavioral trait causes us to ignore “old” information in favor of more recent data. For example, even though many studies have consistently shown that stocks deliver higher average returns than bonds, when more “recent” information becomes available—usually, a slide in stock prices—invariably, some investors will interpret this “new” information as a reason to sell stocks and buy bonds. Naturally, when the stock market readjusts and resumes the long-term upward trajectory it has held for so many years, many of these same investors will sell their bonds and buy stocks—again acting on “new” information—even though the transaction costs, combined with being out of the stock market for some portion of the rising action, will cost them in overall investment performance.
3. Confirmation bias
This tendency causes us to give stronger heed to information that confirms what we already believe and, at the same time, to ignore or gloss over information that contradicts what we believe. This may be the most dangerous behavioral bias of all. The principal antidote for it is the evidence-based, peer-reviewed approach to investing that utilizes all the best available data—not just the information we already agreed with.
A qualified investment advisor can help you avoid these and many other behavioral biases that, whether you are aware of having them or not, undermine the investment performance of so many individuals. The markets are efficient, and logic, along with proven principles, is the key to harnessing their power for your long-term benefit.
Stay Diversified, Stay Your Course!