If investing and saving for retirement were based solely on objective mathematics, a very healthy nest egg could be a forgone conclusion for many of us. Realistically, however, investors are human beings, with wants, feelings, conflicting priorities and a wide range of emotions. In fact, a subfield of behavioral economics called behavioral finance studies how psychological influences and biases affect the financial behaviors of investors.
While there are many facets to behavioral finance and complexity behind the science, some of the concepts I see at work in my daily practice can be simplified to help the average investor identify and change damaging thoughts and behaviors. These include the emotional biases of overconfidence and herd behavior.
Watch Out for Overconfidence Right Now
Overconfidence is an emotional bias that I see most at work in an up market. When individuals see impressive gains in their portfolios, it can distort their decision making. "Winning" can create emotional highs and disconnect us from rational behavior.
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For example, one individual I know is in her 60s and unemployed, with her assets invested in high-risk instruments. While she is focused only on the gains she is currently experiencing, I have asked her to recognize how much those investments can go down in the future — to the tune of about 25% of her funds and hundreds of thousands of dollars. Despite my best attempts to encourage her to diversify and spread risk, she continues on her current path of unrealistic optimism, with huge losses only a market downturn away.
In addition to being overconfident in the market, an investor can also be overconfident in his or her own abilities. After all, we all think we are great drivers, yet more than 36,000 traffic fatalities occurred in 2020, according to the National Highway Traffic Safety Administration. Like driving, investing has inherent risk. We need to be aware of the risks and take steps to migrate those risks. Just like seatbelts cut down on our risk of dying in a car accident, exercising prudence and caution in a financial plan can help protect us from devastating losses.
Therefore, when looking at your investments, exercise some introspection about your level of confidence.
- Are you giddy because your portfolio is so high?
- Have you taken steps to also consider what your losses might be, and can you comfortably accept those losses?
- Are you ignoring the voices of financial experts who are encouraging prudence?
Feel the Urge to Follow the Herd? Don’t You Dare
Likewise, another emotional bias is herd behavior. In essence, we may ignore our own inner dialogue of caution or the advice of professionals and instead “follow the crowd” and its strategies. The most detrimental way I see this at work in my practice is when an up streak is featured throughout the news. This triggers “herd” investors to buy stocks (at a high price). When the news is then filled with market declines, and they see their accounts tumbling, herd investors sell (at a low price). People also do the same in their 401(k)s, transferring money between sub accounts at the worst possible times. All in all, the buzz of “now” gets into their heads, and the old adage of “buy low and sell high“ goes out the window.
Following the herd is a devastating way to manage investments, and the best things to do are ignore what everyone else is doing and remind yourself of your overall plan, which should include diversification, taking a long-term view and rebalancing your assets.
Before you look at your plan, again ask yourself if you are prone to emotional bias — this time, herd behavior.
- Do you have a track record of moving money out of accounts or investments at a loss, and then moving money in or purchasing when the market is up?
- Do you worry about your accounts when you hear that the market is up or down and itch to take action?
- Are you ignoring your long-term plan and acting out of fear or glee?
Prudent investing requires patience and thoughtful decisions to help you reach your retirement goals and balance out the ups and the downs. Taking a good hard look at your emotions and biases can be the first step to improving your investment strategy for the long-term. Be honest with yourself if you see a pattern of mistakes and take steps to ensure that your emotions don’t get the better of you.
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