Theory and practice are fundamentally different. Just because we know the right thing to do under certain circumstances doesn’t mean we will always do that thing when the time comes.
You may know dipping into your emergency fund for immediate needs may not be ideal, yet many are tempted to do it. Most people understand exercising and eating healthy foods can help them stay fit, yet many don’t follow what they know to be the best advice. Similarly, you may be familiar with sound long-term investment strategies and advice, yet have a hard time bridging the gap between that knowledge and its application when it comes time to building a nest egg, investing your savings and managing your money.
Something deeper is at play here, and it may have little to do with money smarts. Let us call these know-one-thing-do-another moments “behavioral errors,” a general term that we use to describe the impact of emotion or lack of discipline on your investment performance.
Behavioral errors can cost you, big time, particularly when it comes to managing your money. They can potentially eat into your investment returns over the long haul, putting your longer-term financial goals at risk. Where do investors tend to make these mistakes? In more places than you might think. For example, wisdom tells you to diversify your investment portfolio across individual stocks, bonds and other securities. Yet many investors stray from these basic, robust, and time-tested investing principles. Instead of diversifying, they tend to over-concentrate their investments into just one sector or a handful of companies.
Additionally, trying to time the market can lead to disastrous financial results. Trading after markets turn rocky can often mean selling your stocks after they’ve dropped then buying stocks back after they’ve rebounded—in other words selling low, buying high and losing money.
A range of motivations may tempt investors to act in ways that deviate from the most likely path to financial or investment success. Having a basic understanding of behavioral finance may help you stay disciplined in trying times.
Behavioral finance is a subfield of economics that focuses on how and why individuals act in ways that are not always rational. Behavioral finance aims to identify and understand the psychology behind investing decisions. Why do investors tend to chase stocks right before they fall? Why do people who try to buy low and sell high end up doing the opposite? Why do people tend to mistake a bull for a bear (at the end of a bear market), and a bear for a bull (at the end of a bull market)? These are some of the things behavioral finance investigates, with special emphasis on behavioral biases and errors. More broadly, the insights of behavioral finance complicate the classical economics assumptions that markets are perfectly efficient and market participants are always rational.
So what are some key insights you can glean from behavioral finance, and how can you apply these insights to your investment decisions and your portfolio? One way is to understand common behavioral errors investors make when they invest and be on the lookout for these pitfalls.
FOMO, or Fear of Missing Out. Most people have experienced FOMO at some point—whether in the realm of investor or otherwise. Perhaps a stock or exchange-traded fund (ETF) is taking off. Meanwhile, you are calculating all the returns you could have made had you invested in that stock earlier. In this scenario, you may be swayed by recency bias—projecting the current performance of the stock price into the future based purely on sentiment. You feel compelled to invest in the stock or fund and you decide to chase the investment—essentially chasing heat.
But as is often the case when chasing heat, the demand for the stock, ETF or mutual fund that you just snatched up may slow down if its price gets pushed too high. Worst-case scenario, investor sentiment fades, fundamentals can’t meet previously sky-high expectations and you are stuck with a sinking investment. Sure, the stock, ETF or mutual fund might be a good asset to own over the long term, but many investors who have chased heat only to catch a cold asset end up “buying high and selling low,” and trading too frequently.
Myopic Loss Aversion. Myopic loss aversion is the idea that we tend to experience pain from losses more intensely than the pleasure we experience from gains. It is a form of “loss aversion” that blocks objectivity in favor of a fear-based valuation. And it is described as “myopic” because it prevents you from seeing the longer-term context, inflating the loss into something much larger than it really is.
Ultimately, viewing your investments from this myopic loss aversion lens can cause you to make bad decisions. You may end up selling your stocks during a correction—a sentiment-driven drop of about 10% to 20% during a larger bull market—when you should be holding them and climbing the proverbial “Wall of Worry.” Or you may flee to alleged “safe havens” such as annuities or gold, when your prospects for portfolio growth or income might be better if you keep holding stocks and bonds instead. Maybe you delay your entry into an emerging bull market during the most opportune (typically the most fearful) moments of a downturn.
Acrophobia. In investing, acrophobia is the fear of jumping into a market that appears to have risen too far, too fast. Suppose a stock or index fund has reached an “all-time-high.” This isn’t the same as saying it has reached a “peak.”
And what if the market undergoes a brutal plunge in the form of a sentiment-driven correction after reaching that all-time-high? Doesn’t this constitute the proverbial “Wall of Worry” investors often have to climb to reach new heights? But if you suffer from investing acrophobia, you may use all-time highs as a reason to exit the market, just in time for the bull to keep climbing while you sit on the sidelines.
Favoring Ineffective Action over Effective Inaction. When something’s going wrong, a common human instinct is to do something. After all, doing something is better than doing nothing, right? Not always when it comes to investing. Waiting and not acting may at times serve you best.
For example, staying disciplined through daily market shocks content may help you make better and more calculated decisions when managing and trading your portfolio. We believe market corrections are impossible to reliably time, as they can come and go for any or no reason. So, in the case of corrections, doing less is often the best course.
These four common behavioral errors—fear of missing out, myopic loss aversion, acrophobia and the tendency to take sudden and impulsive action—may be the tip of the iceberg from a behavioral finance perspective. But this iceberg is often noticeable enough to avoid, which ultimately can make a big difference when it comes to staying on course toward your longer-term financial goals.
Investing can be challenging on many levels. But perhaps the biggest challenge is that we are human and vulnerable to fear, greed and worry. When it comes to investment advice, having a second opinion from a knowledgeable and experienced adviser who can help counsel you against falling prey to your own natural tendencies may add value to your investing. If so, Fisher Investments is here to help. Contact us today.