It’s been a bumpy ride for stocks in the first full week of 2015. And if you’re one of the many investors who vowed to be smarter with your investments in the New Year, you might be a little rattled.
Cass Sunstein, a professor at Harvard Law School who studies behavioral economics, has some advice: Be informed but don’t follow the pack. Sunstein’s new book, "Wiser: Getting beyond groupthink to make groups smarter," explores how decisions are made and how people are influenced by those who surround them both at work and at home.
In the attached video, Sunstein tells Yahoo Finance’s Jen Rogers that, in investing, a herd mentality often takes over. We see what other people are doing, what they are investing in and we want to get in on big gains. “One contributor to the financial crisis was that people were herding towards investment behavior that wasn’t so good,” says Sunstein. Many Americans were taking out mortgages they couldn’t handle, believing that real estate values were going to rise. “People kind of cheered each other on in doing that,” Sunstein says. Then an overwhelming number of Americans couldn’t afford to pay for their homes, a wave of foreclosures swept many cities throughout the country, home prices dropped... you know the rest of the story.
So how do you avoid investing mistakes? It’s important to do your own research, pay attention to news and don’t give into personal fears, says Sunstein. “Availability bias”—something Sunstein has written about—is a mistake many investors make. It involves action based on something that has happened in the recent past (in other words, drawing on an “available” memory of the event). The problem, though, is that people tend to exaggerate the likelihood that the same event will happen again. So if you were burned by the financial crisis, you’re probably still a little gun-shy, even though we're in the seventh year of a bull market.
The other tendency that clouds investors’ decision-making is loss aversion. Humans are hard-wired to be loss averse, and as Sunstein points out, it's difficult to fight human nature. This leads to many investors taking money off the table when they sniff the slightest bit of fear in the air. “In a hunter-gatherer society, if you’re at risk from a tiger, you’re going to lose your life,” says Sunstein. “But if you’re investing in the stock market and you’re loss averse, you probably end up being too cautious and in a way face worse losses in the long run.”
Even Sunstein, who is keenly aware of loss aversion, admits he's experienced it regarding money and it's led him to investment mistakes. In 2011, fearful of a market drop, Sunstein pulled out of a highly-diversified, passively-managed index fund. “I didn’t want to lose money. And as a result of not wanting to lose money, I lost money,” says Sunstein. The fund, which he didn’t disclose, has since soared. “I should have just stuck where I was with a diversified portfolio. That wasn’t a disastrous decision, but it was a foolish decision.”
So what’s Sunstein’s advice for investors? “Get a diversified, passively-managed, low-cost index fund and then do watch the news, maybe rebalance if things get out of whack.” But, he says, “Pay attention to your life, not your stock.”
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