Bad Behavior Can Hurt Your Investments
Studies say that 15% of the time that we are absolutely, positively right about something, we're actually wrong. That's overconfidence, and it can be a financially dangerous behavior for investors.
Behavioral finance studies our irrational investment decisions. John Nofsinger, an expert in the field and 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 missteps fall into three categories.
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."
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."
Simplification. Investors tend see patterns in random events, such as stock price movements, and 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.
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.
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.
Control your investing environment. "Limit activities that magnify your biases," suggests Nofsinger. That may mean avoiding Internet chat rooms and message boards, checking your investments just once a quarter, and relying on an objective professional financial advisor to keep you from behaving like a bad investor.
NOTE: This article was written by a professional financial journalist for CSH Investment Management LLC and is not intended as legal or investment advice.