Most of us consider ourselves logical and objective when we invest (or make any decision, for that matter). Yet subtle biases and behaviors strongly influence us.
Here’s what to guard against when handling your money.
Recency bias – This tendency to use past events to predict future success shows up as you pick investments based on the holdings’ recent performance (aka chasing returns).
For example, perhaps you once picked a fabulous oil and gas stock or fund that was performing exceptionally well. Scrutinize your portfolio now and you see that your energy holding disappoints you. Some people, figuring that energy investments will continue to crater, might sell.
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A decline in your investment today doesn’t necessarily mean you chose poorly; in fact, this might be a good time to buy more of the same stock. Short-term trading can net big gains or big losses. Returns on stock indexes such as the Standard & Poor’s 500, however, show steady gain over time.
Confirmation bias – We all seek out information that supports our own view on a subject. How does that affect us in investing? When you like a specific investment, you tend to read or listen to only positive information about that investment or company.
For example, you may think gold a good investment because you believe that inflation is about to kick in (a possible fallacy, by the way). Naturally you read and remember only news articles and other reports supporting gold’s importance as prices rise.
Negativity bias – We tend to recall bad memories instead of pleasant ones. So when we hear bad news – about, say, a down day on Wall Street – we often give that information more credence. This bias can devastate your investing; you might be inclined to sell on the market dips, hurting your returns.
To help avoid the effects of this bias, set an investing plan and stick to it. The market remains unpredictable and be leery of anyone who says otherwise. If you need guidance, seek a professional adviser.
Herding – Often, everybody simply follows the group. Remember investing fraudster Bernie Madoff, whose investment firm was hugely popular among the wealthy set, or the dot-com bubble that temporarily inflated technology equities in the late 1990s? Investors flocked to both, and paid the price.
Always research an investment before handing your money over. Sources of important information include:
Yahoo Finance, where you can find a stock’s ticker symbol as well as the current and historical share price and the equity’s recent performance, among other details.
The U.S. Securities and Exchange Commission’s EDGAR database helps you locate companies’ annual reports, prospectuses and other background documents.
If the company’s operations don’t make sense, you probably shouldn’t put your money in the stock. Also, remember that if everyone else invests in a hot or well-publicized stock, the equity might quickly become overvalued due to optimism rather than fundamental quality.
Again, seek a professional adviser if you need help.
Overconfidence – Ever been absolutely sure that you were right about something and eventually discover that you were wrong? Of course you have – and you’re not the only one convinced you can pick a winner stock or outsmart Wall Street. Some professional fund managers think they have extraordinary gifts.
Don’t let overconfidence fuel impulsive investments. Create a well allocated, diversified portfolio based on your individual needs and risk tolerance and rebalance your holdings regularly and with discipline. Research also shows that overconfident investors tend to trade more often, increasing trade fees.
Loss aversion – In general, we’re highly loss averse, feeling a loss 2.5 times more strongly than we feel gains. Rather than risk a loss, we tend to become paralyzed. Again: Diversify your portfolio, exercise discipline when investing and try to leave your emotions and harmful behaviors out of the market.