Beginner’s Guide to Market Volatility

This cognitive bias 'really hurts your returns,' says 'Anxious Investor' author: How to overcome it

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Key Points
  • "When it comes to investing, we're overconfident in almost every way imaginable," says Scott Nations, author of "The Anxious Investor."
  • Overcoming cognitive biases as an investor comes down to acknowledging your habits and sticking with your long-term plans.

Given the current turbulence in the stock market, now seems like excellent timing for "The Anxious Investor" — a new book from Scott Nations, president of investment volatility analytics firm NationsShares. "People are anxious," he says. "Inflation is spiking. The Fed is raising interest rates. There's war in Europe."

Books aren't written and published overnight, however, and Nations is the first to admit that as timely as his new title is, he was really taking a more evergreen approach to investing advice when he set out to write it. "Say things were going swimmingly and inflation was under control. That's when people get overconfident," he says. "These things never come to an end. It's always timely."

The "things" that Nations is referencing are 15 cognitive biases that he says consistently lead investors to realize worse returns from their portfolios. While chatting with Grow, Nations focused on those that he sees as having the most pernicious affect on investors' returns.

The worst offender? "Almost certainly overconfidence," he says. "[Economist and psychologist] Daniel Kahneman said that overconfidence is the one bias he would do away with if he had a magic wand. It really hurts your returns."

How 3 common investor biases can cost you

Overconfidence. Investors tend to think they can outfox the market. Generally, they're wrong, notes Nations. "When it comes to investing, we're overconfident in almost every way imaginable," he says. "We overestimate our ability to pick winning stocks, construct well-diversified portfolios, and get in and out of the market at the right time."

This bias typically leads investors to take a lot of action when it comes to their portfolios, which ends up costing them, Nations says.

"One example I cite in the book is research in which they divided huge swaths of portfolios into quintiles by how much people traded," he says. "Return, over time, [was] directly correlated to how much they traded. The more you trade, the less you make."

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How cognitive bias affects your investments

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Availability bias. This is the phenomenon leads investors to think situations they can clearly remember are more common than they actually are. Because investors tend to remember market catastrophes, they can begin to panic when markets show signs of shakiness, says Nations.

"Nobody alive now was an investor in 1929, but every investor knows it happened. On the other hand, do you know what happened in 1961?" he says. "If you can remember something specific that happened in the market, then it was almost certainly not normal."

Loss aversion. "Research shows that we hate losses about twice as much as we like the same amount of gain," Nations says. "That causes investors to do goofy things." Namely, they tend to sell investments after they've fallen, out of fear that they could deliver more painful losses.

Nations points out that investors sold in record numbers toward the very end of the 2007-2009 bull market, effectively selling their portfolios "at the bottom." By the time many of them were comfortable with buying back in, the market had already climbed significantly.

"Basically, they bought at the top, sold at the bottom, and bought back in at the top," he says.

How to keep your biases from costing you money

Don't feel bad about your biases, Nations says. They're extremely prevalent. Virtually all investors Nations studied let their biases hurt them financially over the course of three recent market crashes.

"I use those examples because it's easy for someone to read that and think, 'Oh, I do that a little bit,'" he says. "The goal was to allow people to recognize what they're doing without lecturing them."

Some of the biases Nations mentions can be thwarted by taking a second to examine your behavior. Maybe you're finding yourself catastrophizing about the state of the market. Maybe you're seeing all of your friends on social media buying or selling a certain investment and feel the need to do it too. (That's another common bias — the "herding" effect — at work.)

In those cases, it pays to step back, remember the goals you're investing toward, and return to an analysis of an investment's fundamentals before making a purchase.

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The other way to make sure you're not falling prey to biases is to make a long-term plan and stick to it while ignoring the noise coming in through your TV screen and social media feeds. "You don't have to be smarter than the market," Nations says. "If you invest a little bit every month, consistently, the market" can do the work for you.

The strategy Nations describes, known as dollar-cost averaging, will ensure that you buy more shares when stocks are cheap and fewer when they're expensive. Sticking to that plan — or even setting it to run automatically — can help keep you from making rash decisions with your portfolio.

"Focus on investing consistently and using low-cost products," Nations says. "If you have a 30- or 40-year timeline, there's no need to get carried away about what's going on with the market."

The views expressed are generalized and may not be appropriate for all investors. The information contained in this article should not be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product. There is no guarantee that past performance will recur or result in a positive outcome. Carefully consider your financial situation, including investment objective, time horizon, risk tolerance, and fees prior to making any investment decisions. No level of diversification or asset allocation can ensure profits or guarantee against losses.

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