There’s a battle between our heads and hearts when making investments. When emotions take the lead–as they usually do, we become our own worst adversaries and are unable to outperform the overall market. Based on DALBAR research, one of the single most important factors in the performance of investments is the behavior of investors. It’s the main reason behind the constant underperformance of the typical equity investor in mutual funds against that of the U.S. equity market.
These findings don’t surprise me. I’ve observed firsthand how the biases of behavior and emotion can result in poor choices and eventually disappointing performance. The main preferences that I watch most often are loss aversion media response, herding, confidence, and familiarity. You might recognize one or some of these in your own decisions.
Loss Aversion
Many clients seeking advice from me think they will achieve high returns while taking minimal or no risk. They’ve made a few wrong financial choices to stay clear of loss, often based on the assumption that anything that goes down should always rise. They’ve sold their investments that have increased in value and are now in the process of waiting for “losers” to grow. In most cases, they’re holding the less profitable business and selling one that was more profitable. Please take a look at it in the context of real estate. Do you want to hold onto an unprofitable house in a depressed neighborhood or sell it?
Herding
People feel more secure when they are a part of the crowd. The tendency to follow in the footsteps of others is referred to as herding behavior. Investors are prone to herding when they sell because others sell and buy due to others leaping the markets. In the end, they are more to be expected to sell at a low price and buy at a high price, which is in opposition to common sense and harmful to the performance of investments. Warren Buffett has profited from not following the crowd. He’s made a fortune as an investor who is a contrarian and is reported to have said, “You pay an expensive cost in the stock market to get a positive consensus.” I agree with the same view.
Media Response
The media’s job is to boost the number of viewers and readers they can reach, and the most effective method to achieve this is to focus on negative news and amidst crises. The daily information about financial events can cause investors to narrow their eyes and miss the larger picture. The heated debates about market developments and the opinions of “experts” create a sense of anxiety and trigger snap actions based on fear or greed. Utilizing your brain and not your heart and taking a longer-term view of the market could yield better results without the stress.
Overconfidence
Confident investors believe that they can predict the market, and nobody could convince them that they’re not. Some have unrestrained optimism and an “It will never occur for me” attitude.
These overconfident investors will find it challenging to listen to the opinions of an investment expert. They usually come back to earth when they’ve suffered a loss on the market and rebuild their portfolios so that they include more protection against the risk of a downturn. Naturally, the repercussions of being overconfident can be more severe when you’re older and have less time to recuperate the losses.
Status Quo Bias
We often feel more at ease with things the way they are and maybe reluctant to change things even though we are aware that we must. This is known as status quo bias and is at the root of many bad financial decisions, like the failure to make changes to an investment strategy that is more conservative as time goes by. Many investors who’ve been aggressive for years aren’t comfortable having a riskier portfolio and do not adjust their portfolios to match their time horizon or make adjustments too late.
One of the most significant advantages of having a financial advisor is accessing their impartiality and knowledge regarding investment decisions. One major reason why many wealthy families and individuals don’t manage their own finances is due to the fact that they need impartial advice.
Behavior and emotional biases are mostly subconscious and automatic, making them difficult to manage. At a minimum be aware of the triggers that cause an emotional reaction within you. Don’t be afraid to consult a financial advisor to help you stay calm and avoid making decisions that you’ll regret later on.
