5 biggest pitfalls for investors
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Humans have evolved by being survival-based creatures. If we take a look back, (like way back!), our brains had to evolve to protect us from all kinds of primal dangers like saber-toothed tigers, earthquakes, and diseases. The trouble is that our instincts and navigating the twists and turns of the financial markets are two worlds that simply don’t mesh well. Our instincts aren’t just unhelpful – they can actually be harmful when it comes to riding out a rocky stock market. It’s very easy to fall back on gut decisions and intuition, but while these tendencies seem rational, but can be self-defeating. In today’s Coffee & Cash, we’re going to review 5 mental pitfalls to avoid when dealing in the everchanging world of our economy. Knowing how we are hard-wired to react to certain events and triggers can be helpful in allowing us to manage our emotions and become better investors:
Loss aversion – Loss aversion occurs when the fear of loss is a stronger motivator than the joys of gain. Fear of loss can cause investors to invest too conservatively and overreact during market volatility. Low-risk investments often lead to low-returns, meaning your money may not grow enough to reach long-term goals like retirement. A great way to avoid this is to focus on your timeline. Let’s say your goal is 20 years away. If you have adequate cash on hand for your short-term needs, a loss over a month or a year probably isn’t going to change the scales too much in comparison to your overall time horizon. Selling out of your investments at a bad time however, will likely have a long-term negative impact on your overall returns.
Anchoring bias – Anchoring bias is when we latch onto the first information we find, regardless of whether it is relevant or not. For example, say your friend bought an investment at $100. By the time you look at the investment, it is trading at $110. You decide not to buy because now it might be overvalued. The problem here is that what your friend bought the stock at is actually irrelevant. How do you prevent this? Ignore the anchor. Do your homework. When looking at stocks and bonds, consider investment fundamentals like earnings growth, price-earnings ratios, and interest rates. Also consider how these investments would fit into your overall financial plan.
Herding bias – There’s safety in numbers, right? Well, not necessarily. The popularity of an investment doesn’t necessarily mean it’s right for you or that it will produce a great return. Think about cryptocurrency in 2021. Many influencers purchased large amounts of cryptocurrency then encouraged their audience to buy, causing the values to skyrockets. Fast forward a few months, and most of those investments have lost most of their value. The best remedy for this? Build your portfolio around you - your starting point, your financial goals, and your time horizon – not the hottest trends. Diversifying your portfolio, or owning a mix of investments, can help you reduce risk and create a balance of falling and rising investments. Remember that the crowd is often wrong. Think about internet stocks in 2001…
Ambiguity aversion – As the saying goes, “it’s better to be with the devil you know, than the devil you don’t know”. Unfortunately, that’s not always the case when it comes to investments. Of course, people tend to be more comfortable with things that are predictable and often shy away from uncertainty. You may be tempted to load up on investments that offer predictable returns like money market funds or CD’s with a fixed rate of return, however, sometimes sticking to your comfort zone can be risky. For example, if your goal is to grow your money over a long period of time, investments with predictable or guaranteed returns are often low-risk, low-return. Being overly conservative over a long stretch of time can lead to what Don Simmons likes to call “going broke safely” once the impact of inflation and taxes have been taken into account.
Confirmation Bias – When we exhibit confirmation bias, we tend to seek out information that confirms or supports what we already believe and reject information that doesn’t. The issue is that limiting yourself to information that confirms what you already think can be a significant issue for investors, causing them to miss important signals that might otherwise help them to make adjustments to their investment strategy.
Understanding the mental short cuts we’re primed to take is the first step in combating their influence on our decision-making. A solid financial plan that’s focused on achieving your individual goals helps remind you of your priorities in times of uncertainty and fear.
If you have questions about your own financial plan, or perhaps you don’t have a plan at all, please feel free to give us a call or book a free consultation through the link on our website. We’re happy to help!
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