Know the pitfalls of investing psychology.
We all are led by primal instincts sometimes. And those instincts can help us make decisions on whether to wait for a good opportunity or cut our losses and leave when situations are bad for us. But those same primal instincts can work against us when it comes to investing, and create psychological biases that have us avoiding things we're unsure of, or divesting when prices drop instead of reinvesting. Without risk, there is no innovation, after all. Here are some known pitfalls when it comes to investing psychology.
Your home is your comfort zone, but it shouldn't mean everything to your investment portfolio. "For example, people living in the U.S. will tend to overweight their portfolios to U.S. stock compared to diversifying with world markets. Similar behavior is observed when looking at portfolios of people living in the U.K., Japan, Germany, etc," says Josh Trubow, a financial advisor for Sensible Financial Planning. "People with home bias are hurting their investing potential because they are not as well diversified as they could be." They may even be ignoring opportunities in developing countries.
Making the easy choice.
Known fact: You're more likely to buy something if you think it's an easy choice. "Interest in enrolling in a retirement savings program involving some risk was increased by asking the consumer an easy instead of a difficult question about finance," says consumer psychologist and retail consultant Bruce Sanders, author of "Sell Well: What Really Moves Your Shoppers." But when people were given an abundance of technical information about a particular mutual fund, the people reported a drop -- not a climb -- in their subjective knowledge, and thereby became less willing to invest in that fund. "Similarly, when feeling cognitively overwhelmed, we drawback from investing," he says.
The gambling mentality.
If you're thinking of your stocks as gambling, then you probably haven't done enough research about your investments. "The gambling mentality is a huge detriment to long-term success in investing," says Patrick McDowell, investment analyst of Arbor Wealth Management. Although most investments do contain risk, "a successful investor thinks about stocks as proportional shares of businesses to be bought or sold when appropriate for their own situation, not as pieces of paper to gamble with," he says.
If you keep significant cash in six-month CDs, "just in case," you're missing out on the higher interest, says William A. Stack, financial planner and best-selling author of "The 7.0% Solution." "Why not put $10,000 to $20,000 in an insured five-year certificate at 3 percent that you can add to at any time, including after the five years is up? For the life of the certificate, it will always earn at least 3 percent, including after five years when it is fully liquid. From that point on, for the rest of your life, you have somewhere to stow funds that are paying 10 times the current savings rates, with the ability to access the entire balance at any time."
Humans seek to identify patterns, but this can cause misjudgment in investing. Following the financial crisis of 2008-2009, many investors focused on defending themselves against another market freefall, rather than on seeking opportunities to profit from the recovery as conditions stabilized, says Benjamin Sullivan, certified financial planner and portfolio manager with Palisades Hudson Financial Group. "We are prone to pay undue attention to recent news, either good or bad, and as a result we may underemphasize long-term averages or trends," he says. "It's an adage in financial planning that past performance is no guarantee of future results."
Most people believe they are better at a variety of skills than they really are, Sullivan says. "To make matters worse, most of us believe we are less overconfident than other people." In investing, overconfidence can create problems such as under-diversifying a portfolio or trying to time the stock market instead of sticking to a long-term plan, he says. "Overconfidence frequently leaves investors with eggs in far too few baskets and with those baskets dangerously close to one another," he says.
Your gut can be useful, but, similar to overconfidence, with this kind of thinking you'll grasp at any kind of information that confirms your thinking. Financial advisor Jeremy Torgerson had a client who was absolutely certain the markets were going to drop by 40 percent or more, and that 2016 was going to be another 2009. And he said his hunch was confirmed by a CNBC report. "He didn't even know the name of the person he saw on CNBC. He just knew that someone had said back to him what he wanted to hear, and that was enough," Torgerson says. "He took a significant tax hit to sell investments he'd had for years."
Aversion to loss.
Nearly all of us suffer from some degree of aversion to loss, which leads investors to hold on to losers too long in order to avoid acknowledging an investing mistake, Sullivan says. "Only the potential future return on the investment, and the associated risk, should matter when deciding whether to hold or sell an investment."
Bandwagon (herd) mentality.
If you're thinking if everyone is doing something, they must know something you don't. "This is pretty self-explanatory, but it runs completely counter to how you should invest," Torgerson says. "Warren Buffett was once asked for the secret to his investing success. He said he got nervous when others get greedy, and got greedy when others get nervous. That's a quaint way of saying he bought low and sold high, exactly what we are told will bring investing success."
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