When it comes to money and investing, we’re not always as rational as we think we are, which is why there’s a whole field of study that explains our sometimes strange investment behavior. It is important to control your emotions and avoid self-destructive investor behavior. We call the gap between general market returns and individual investment performance “investor behavior penalty.” It is possible for investors to negatively affect performance due to their numerous behavioral & emotional flaws. Why is this?
Greed and overconfidence
People generally overestimate their knowledge and their abilities to make financial decisions, either by overconfidence or by personal doubt. Many investors believe they can consistently time the market. But in reality there’s an overwhelming amount of evidence that proves otherwise. Overconfidence results in excess investing or inappropriate investing. Personal doubt can arise from a history of bad money decisions or financial losses and trials. Generally though, too many people do not know how to determine their investment objectives or their tolerance for risk. They don’t know how to choose an investment or where to turn for help.
Fear and regret
The current investing public suffer from short term memory loss (of the recent market losses in 2008-2009) or remain paralyzed with loss aversion. Fear and regret deals with the emotional reaction people experience after realizing they’ve made an error in judgment. Faced with the prospect of selling, investors become emotionally affected by their purchase price. So, they avoid selling it as a way to avoid the regret of having made a bad investment as well as the embarrassment of reporting a loss. We all hate to be wrong, don’t we?
Loss Aversion Theory suggests people express a different degree of emotion towards gains than towards losses. Individuals are more stressed by prospective losses than they are happy from equal gains. This explains why investors hold onto losing stocks and why people often take more risks to avoid losses than to realize gains. For this reason, investors willingly remain in a risky investment, hoping the price will bounce back. Gamblers on a losing streak will behave in a similar fashion, doubling up bets in a bid to recoup what’s already been lost.
Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic during downturns. Extreme cases of over- or under-reaction to market events may lead to market panics and crashes. Fear can cause rational people to ignore the financial facts that make up their plans and irrationally deviate due to reaction to news or the crowd’s behavior.
Investors must learn to use the media, and not let it use them. We need to realize that markets go up and down, and that this volatility will always be part of investing. We need to set up and stick to longer term plans utilizing this volatility not running in and out of in. We need to discern what media we listen to (you can’t listen to all of it). Even with all the technological advances and financial resources, we are not immune to boom and bust cycles of the markets, effects in regulatory and governmental change, and markets that can incite us to bad investment behavior.
That said, investors can be their own worst enemies. Trying to out-guess the market doesn’t pay off over the long term. In fact, it often results in quirky, irrational behavior, not to mention a dent in your wealth. Implementing a strategy that is well thought out and sticking to it may help you avoid many of these common investing mistakes.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results
Jeffery Masters, president of Jeffery W. Masters & Associates, can be reached at 954-977-5150. Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Independent Financial Partners, a registered investment advisor. Independent Financial Partners and Jeffery W. Masters & Associates are separate entities’ from LPL Financial – Jeffery.Masters@LPL.com
Jeff is a locally endorsed Investment Advisor by Dave Ramsey, who is not affiliated with LPL Financial.