As investors, we seem to be hard-wired to fail.
“The investor’s chief problem – and even his worst enemy – is likely to be himself,” Benjamin Graham, the godfather of value investing, famously said.
Individuals make the same mistakes over and over again due to biases apparently coded into our investing DNA. The growing field of behavioral finance has pinpointed several emotional and psychological tendencies that often lead to irrational behavior.
Here are five common psychological pitfalls and how investors can avoid them:
1. Loss aversion: They say generals are doomed to fight the last war. The same could be said of investors. It’s not surprising that investors are wary of stocks after suffering through the dot-com meltdown and 2008 financial crisis. This has caused many to watch from the sidelines during the bull market that started in March 2009, one of the most powerful in history. This is loss aversion at work. Essentially, people feel the pain of losses about twice as much as they enjoy the same gain. Perversely, loss aversion also drives investors to hold on to losing investments much longer than they should. To correct these mistakes, it’s important to look forward rather than backward, and to take losses so capital can be deployed to new and better opportunities.
2. Anchoring and confirmation bias: We tend to cling to our initial impressions on issues or the first piece of information we get, which behavioral economists call anchoring. Even when a position is refuted by cold, hard facts it’s difficult to change a person’s mind, which is known as confirmation bias. Successful investors look for reasons why their original thesis could be incorrect, rather than facts that simply confirm their idea.
3. Overconfidence: Most of us think we’re more attractive than we really are, and the same applies to our investing prowess. Overconfidence hurts investors when they trade too much, rather than maintaining a long-term mindset. Overconfidence can also cause investors to take on excessive risk with too-big positions, or hamper them from changing their thesis when the facts and circumstances change. “The most common bias we come across is over-optimism. That is people’s tendency to exaggerate their own abilities,” says James Montier, a member of GMO’s Asset Allocation team and author of several books on behavioral investing. Professional investors also suffer from overconfidence, with a 2006 study by Montier revealing that 74% of fund managers said they were above average at their jobs. Unfortunately, we can’t all be better than average. A little humility isn’t a bad thing, and investors should remember they’re likely to be wrong more than right.
4. Recency effect: This is another common behavioral bias that leads to unfortunate investing decisions. Recency effect is our tendency to focus on the latest news and developments while ignoring long-term history. In a bull market, investors tend to think stocks will keep rising, so they’re more likely to buy. When the market is falling, they lose hope and sell. This partly explains why investors shoot themselves in the foot by buying high and selling the low. Investors can help defend against recency effect by studying up on market history and cycles, and trying to keep their emotions in check. Easier said than done.
5. Endowment effect: According to this bias, we tend to place a higher value on things that we already own. Studies by behavioral economists have shown that people demand about twice as much to sell something they own, compared with how much they are willing to pay to buy it. This bias explains why many investors are loath to part with losing stocks and willing to endure losses down to zero. Endowment effect prevents investors from taking the loss and moving on to the next prospect. It’s better to book a small loss than to hang on and lose everything.
Read more about Covestor’s investing philosophy.
Photo Credit: jepoirrier
Disclaimer: All investments involve risk and various investment strategies will not always be profitable. Past performance does not guarantee future results.
