- Herd mentality: Following the crowd isn’t necessarily a good idea.
- Loss aversion: This can prompt you to sell on a dip, locking in losses—or keep you out of stocks altogether.
- Recency bias: Just because the market dropped today doesn’t mean it will fall again tomorrow.
- Confirmation bias: Clinging too tightly to a belief about a stock can keep you from making an informed investing decision.
Whether or not we want to admit it, we all have biases—and that can get in the way of investing success. “Biases can trigger emotional responses,” says Frank Murtha, Ph.D., co-founder of behavioral finance research and consulting firm MarketPsych Insights. “That’s what gets people in trouble.”
That was in evidence after election results rolled in Nov. 8 and the electoral votes tipped in Donald Trump’s favor, a result most pollsters hadn’t predicted. At one point overnight, the Dow Jones Industrial Average futures—which trade when the U.S. stock market is closed—were down more than 800 points, an indication people around the globe were panic-selling stocks. By noon Wednesday, however, the Dow had reversed course and climbed more than 1,000 points from its overnight low, a rally many who’d dumped their stocks missed out on.
Loss aversion, which can trigger such panic-selling when the market drops, is one of four common biases that can trip you up. Take these steps to keep them from sabotaging your success.
1. Herd Mentality
Most people find comfort in conformity and follow the crowd, even if it takes them right over a cliff. In investing, that may lead you to buy pricey momentum stocks without proper research or to sell during a market rout—both potentially costly mistakes.
How to overcome it: Resist financial peer pressure and be yourself. (Good advice, whether you’re 15 or 65.) “Figure out who you are as an investor—your goals, values, beliefs, strengths, weaknesses,” says Murtha. “When you establish those, you have an identity, and that identity allows you to act in your own best interest and not follow everyone else.”
2. Loss Aversion
Losing hurts far more than winning satisfies. That’s because the loss isn’t just monetary; it’s emotional. There’s a sense that maybe we’ve made a stupid mistake. Loss aversion may lead you to sell when the market dips in an attempt to avert further losses should it keep falling (though the market has, historically, rebounded from downturns) or keep you out of the stock market entirely. Both actions could cost you.
How to overcome it: Accept the risk of losing in the short-term in order to win in the long run. Keep your eye on the prize, and remember that a diversified portfolio is designed to weather the market’s ups and downs. And separate your ego from your investments. “If you’re not able to take losses and you’re going to avoid them at all costs, you’re really dooming yourself to an underperforming portfolio,” Murtha says.
3. Recency Bias
What happens today tends to have a bigger impact on your decision-making than what happened in the past. When investors see a few “up” days in a row, for example, they may be tempted to buy under the belief that the market can only go up further, rather than waiting for a dip (when they can get a better bargain).
How to overcome it: Understand market history. In the short term, ups and downs are completely normal. And over the long term, we’ve had a mix of bear and bull markets. Your investing strategy should incorporate an expectation for both. “It’s easy to get caught up in the highs of the highs and the lows of the lows—and make the wrong decisions at the wrong time,” says Curt D. Knotick, financial advisor and CEO of Accurate Solutions Group in Butler, Penn. “Markets will always cycle. You have to look at the long-term perspective.”
4. Confirmation Bias
When we have strong opinions, we tend to easily believe evidence that supports our thoughts and resist contradictory information. That’s because confirming our ideas makes us feel good, while opposition might make us feel wrong and dumb.
How to overcome it: Look at the pros and cons of any investment opportunity to make a truly informed decision, and consider how it fits into your long-term strategy. “Every trade is based on a disagreement—somebody likes it, somebody doesn’t,” says Murtha. “You have to actively seek out the other side…If you’re doing that, you’re behaving like an intelligent, sophisticated, emotionally strong investor.”
November 28, 2016