Investing can be emotionally taxing and at times downright discouraging, especially when you are constantly under-performing the market. Articles, headlines, and even our friends constantly claim they are generating huge returns. But when our returns are lacking, or when the market has a downturn, what do we do?
“The big money is not in the buying or selling, but in the waiting.”Charlie Munger
I’m sure we have all heard the age-old saying “buy low, sell high”, but how do we do that? In this article, we look at 5 psychological fallacies/biases that are making you a bad investor.
According to Dalbar, who releases a Quantitative Analysis of Investor Behavior every year, in 2017, “the average equity fund investor underperformed the market by 1.19%.” Due to this constant underperformance, it has made a lot of investors nervous and has caused a lot to turn to passive ETFs and fixed income products.
But are those really the solutions that will fix the problem of under-performing the market?
We as humans hate being wrong. Due to that we usually look for supporting information that bolsters our preexisting biases. If we believe that stock “A” is going down we will look for information affirms that belief.
The mainstream media is constantly saying that the bull market will continue. Since optimism sells, it is not surprising that a lot of people are buying into the story and looking for information that supports those claims.
Making money and being right are not mutually exclusive.
Gamblers Fallacy is the belief that because something happened frequently in the past, it will happen less frequently in the future or vice versa.
For example, say someone is sitting at a poker table. They have now lost 5 hands in a row. Gamblers fallacy dictates that their luck is bound to change, and they will win a hand shortly. However, there is no empirical evidence for this.
If you have read any disclosure documents for investing, you have probably read “Past performance is no guarantee of future results”. Although this is true, performance chasing is extremely common and often results in under-performing the market.
There are two ways to asses outcomes in any situation; Possibilities and Probabilities. As we mentioned earlier, optimism sells, and possibilities are more optimistic than probabilities.
Anything is possible, but the probability that something will happen can be virtually zero. It’s possible that you could win the lottery, but there is a higher probability that you will die crossing the street to buy the lottery ticket.
We like to think of best-case scenarios. It’s possible that an extremely risky portfolio triples in value, but what is the probability that it will happen?
It is possible that the current bull market will continue on for years to come. However, it is probable that there will be some form of correction based on statistics and past economic cycles.
Human beings long for acceptance. The easiest way to be accepted is to go with the flow and follow the trend. Going against the grain usually leads to rubbing some people the wrong way, and having your position questioned and criticized.
The logic behind herd bias is if everyone else is doing it, it must be correct. However, when you couple this herd behavior with financial markets you can get some pretty unfavorable results… especially if you are a latecomer.
“Oh everyone is buying security ‘B’ that must be the right thing to do.” When the herd thinks this way, it drives excess growth curves and extends the severity of market declines. If you were late to the party and were one of the last ones to buy in, then you probably experience next to no growth before the tide switched and everyone started selling.
Recency bias is the phenomenon that people more easily remember something that happened recently rather than something that occurred a while back. They then extrapolate on this memory and believe that what has happened recently will continue.
A winning streak is only a winning streak until you lose.
We have been in a bull market for 10 years, that seems to be all people can remember. A lot of investors have probably not known anything except for a bull market. However, just because that is all you can remember doesn’t mean there isn’t an alternative, especially if we look further back into history.
People tend to believe that because this is what has happened for the last 10 years, this is what will continue to happen. Every action has an equal and opposite reaction.
The opposite was true in 2008 when the market was in the midst of the financial crisis. After it all settled and the economy started to recover, investors were shy and reluctant to buy back in. Because of this, it took a long time for investors to regain the confidence to be “fully invested”.
These 5 psychological fallacies and bias can cause a lot of stress and ultimately lead to under-performing the market. There are other reasons your returns could be lacking. Make sure you are sitting down with your financial advisor at least annually and going over your investments.
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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy