We use a lot of mental shortcuts to get through our busy days, and some of them can cost us, big time. Behavioral economists who study these shortcuts call them "cognitive biases,” and experts think they can mess with our investment strategies.
Here are five of those biases to watch out for, along with some tips to keep your mind from playing these kinds of tricks on you.
We hate losing money. We hate it so much that studies have found we feel our pain from losses twice as keenly as our joy from wins.
Loss aversion can make people avoid investing entirely, or invest too conservatively. Worse, it can make people react badly to market downturns, says Jeff Kreisler, coauthor of “Dollars and Sense: How We Misthink Money and How to Spend Smarter” and editor-in-chief of the behavioral science site PeopleScience.com.
“How this plays out in the market: People who are actively investing, when the market goes down, will become more fearful of future losses and be more inclined to sell, which isn’t necessarily rational,” Kreisler says.
We’re reluctant to recognize that money already spent is, well, gone. Say your car breaks down and you spend $4,000 on a new transmission. Then, you break down a month later and the mechanic says you need a new engine for $3,500. Your emotional response might be, "I have to pay to fix the engine, otherwise I wasted that $4,000 on the transmission."
In truth, that $4,000 is already gone. It's a sunk cost. Also, odds seem high your old car will keep costing you money, so you are likely better off spending that $3,500 on a new one .
We can overemphasize information that is readily available, such as our personal experiences. That can mean we often overlook the bigger picture, says Jamie Foehl, senior behavioral researcher at Duke University’s Center for Advanced Hindsight.
For example, many millennials who came of age during the Great Recession are scared to invest in the market , having seen early on that investors can lose a lot of money in a crash. “That was pretty hard to forget,” she says.
The years 2008-2009 were hard on investors, but the market did recover, as it has throughout its history. So it's important to not let dramatic events take on too much, or the wrong kind of, importance.
We tend to overestimate our skills in certain areas. For example, about 9 out of 10 people think they are above-average drivers .
Plenty of investors—ranging from professional traders and everyday folks with 401(k)s—also think they are better than average, Kreisler says, and “this leads us to make mistakes,” as “even those who admit they don't know things are still more confident than they should be.”
Once we make a decision, we want to be right, so we tend to block out information that might show we’ve made a mistake and pay attention only to data points that make us look smart. This is one reason people stay with financial advisors even after they’ve made mistakes or proven unworthy of trust .
There’s no way to inoculate yourself against all these cognitive biases. But there are things you can do to moderate their impacts.
- Focus on long-term trends rather than daily market movements. To minimize the emotional swings that lead to cognitive errors, Foehl says, it’s critical to focus on the big picture. Ignore the day-to-day ups and downs of the market and keep a long-term perspective.
- Create a solid investment strategy. Go over your long-term strategy at a calm point when your brain is in a “cool state,” she says. That can help you stick to your plan even when your brain is in a “hot state” thanks to market news.
- Come up with ways to cope. Take steps in advance to help you feel more confident when the market gets bumpy. “It’s kind of like not having snacks in the house or giving someone else your car keys before you go out for a night of drinking,” Foehl says. “You pre-commit to not making a change. You can even write a letter to your future self that says, ‘Stay the course.’”
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