Many hard-wired, fundamentally human qualities greatly interfere with our ability to act rationally when it comes to investing (and many other things). Often our feelings and emotions can obstruct our objectivity when trying to make wise financial decisions.
Much of what makes us human is our complex feelings and emotions. Many are instinctive like “fight or flight.” For example, the feeling of fear, which allows us (and allowed our ancestors) to stay away from danger. Other emotions are often products of our own unique experiences, such as the love of a favorite baseball team, regardless of their win/loss record.
Experts in the growing field of behavioral science attempt to study our natural instincts to explain how we react to different scenarios when we invest. Although there are many behavioral biases we must be aware of, below are a few of the most common mistakes investors make.
When investments (and investors) all seem to be headed in the same direction, whether markets are up or down, it is difficult for investors to fight the urge to join the herd. It is quite common for investors to be swept up in the euphoria of a rising stock market or the panic of a declining market. In the abstract, it is easy to see that buying stocks when they are high and selling when they are low is a sure-fire way to lose money. But in the heat of the moment, the euphoria or panic coupled with our instinct to move with the herd are very difficult emotions for investors to resist.
The average investor believes that they are much smarter than average. An overconfident investor will view successful investments as a product of their superior skill and, conversely, losing investments as a result of bad luck or other factors that are outside of their control. This overconfidence can lead to excessive risk taking and irrationally disregarding the possibility of negative outcomes.
A significant contributor to investor overconfidence is confirmation bias, which occurs when an investor has a predetermined opinion about an investment. When an investor’s mind is “made up” they will often seek out information that supports their beliefs, while at the same time ignoring or deemphasizing information that conflicts with their opinions.
Investors tend to favor investing in familiar sectors and companies. Here in Texas, many prefer to own energy related stocks, in the northeast it’s financial companies, and in the west it’s technology companies. Familiarity bias can lead to investors concentrating their portfolios in certain narrow sectors, while ignoring opportunities in other, less familiar areas.
When investors purchase an investment, they will often “anchor” their decisions for this investment to their initial purchase price. Most commonly, they may continue to hold an investment that has lost money, hoping it will recover to at least “break even.” This, despite the fact that the underlying fundamental value and upside potential that they saw when they made the investment may have declined significantly.
It’s Only Human Nature!
Our human nature, which typically serves us well, can be a significant obstacle to our success as investors. Awareness of the common behavioral mistakes we make can help us to better fight against our primal urges and resulting bad investment behavior. We suggest that you always keep these behavioral biases in mind as you consider your investment choices.
If you would like to discuss our opinions, outlook, or your portfolio in greater detail, we would be happy to schedule a meeting or a conference call at your convenience.
Horizon Advisors is a Houston based fee-only wealth management firm. We specialize in helping successful individuals and families understand, organize, and manage their often complex financial situations. Horizon offers integrated financial planning and investment management services.