Studies say that 15% of the time when we are absolutely, positively certain we’re right about something, we’re actually wrong. That’s overconfidence, and it can be a financially dangerous behavior for investors.
The field of behavioral finance studies our irrational investment decisions. John Nofsinger, an expert in the field of behavioral finance, and the author of Investment Madness: How Psychology Affects Your Investing and What to Do About It and Investment Blunders of the Rich and Famous, says our investing pitfalls fall into three categories.
Irrational Investment Decisions Fall Into Three Categories
- Overconfidence
- Emotion
- Simplification
1. Overconfidence. People exaggerate their ability to pick winners and their control over the market. Unable to admit mistakes, it is common to hang onto losing stocks or funds. “The overconfidence bias causes you to trade too much and take too much risk,” says Nofsinger. “As a consequence, you pay too much in commissions and taxes, and you’re susceptible to big losses.”
2. Emotion. Fear and greed, rather than rational facts, rule many investment decisions. Worse, Nofsinger says, an “attachment bias” can make investors emotional about holdings. “You are emotionally attached to your family and friends, and so you focus on their good traits and deeds and discount their bad ones,” he explains. “When you become emotionally attached to a stock, you may fail to recognize bad news about a company.”
3. Simplification. Investors tend to see patterns in random events, such as stock price movements, then make investment decisions based on these false patterns. Also harmful, says Nofsinger, are the shortcuts people make to reduce complexity. “For example, we assume things sharing similar qualities are quite alike,” he says. But this can lead to inaccurate conclusions. “You may put too much faith in familiar stocks,” he says.
To steer clear of these tendencies, you need to understand the impact they can have on your decisions, and take the time to recognize and avoid them. Nofsinger proposes several strategies.
3 Strategies for Overcoming the Pitfalls of Irrational Investing
- Know Why You’re Investing
- Establish Quantitative Investment Criteria
- Control Your Investing Environment
1. Know why you’re investing. Most people have only vague notions of their investment goals — maybe, “I want a lot of money so I can travel abroad when I retire,” or “I don’t want to be poor when I retire.” Says Nofsinger, “These do little to give you direction. Nor do they help you avoid psychological biases that inhibit good decision-making. So be specific.” During annual portfolio reviews, examine your progress toward your specific goals.
2. Establish quantitative investment criteria. These can help you avoid basing decisions on emotion, rumor, or other psychological biases. Instead, your investments should measure up in terms of price-to-earnings ratios, sales growth, and other quantifiable benchmarks that are important to you.
3. Control your investing environment. “Limit activities that magnify your biases,” suggests Nofsinger. That may mean avoiding Internet chat rooms and message boards, only checking your investments once a quarter, and relying on an objective professional financial advisor to keep you from behaving like a bad investor.
Investing can be intimidating and fraught with pitfalls, especially if you are navigating things on your own. Feeling uncertain about your financial future can be very stressful, and it’s hard to find committed advisors to help. At CSH we believe everyone deserves a reliable financial partner they can trust. That’s why we work with all different kinds of investors — from those who are brand new to those who have large portfolios and have been doing this a while. For over 20 years we’ve given our clients the guidance they need to find peace-of-mind with their investments.
We listen. We plan. You succeed.
Give us a call at 217-824-4211 for an introductory chat. We’ll get to know you along with some preliminary information, and then decide if moving forward is in your best interest.