Emotions vs. Rationality
Have you ever received a quarterly investment statement and been pleased to see a big gain after a good quarter of returns? The emotions we feel are often optimism, satisfaction, happiness, and contentment, while conversely checking our statement after a bad one (think 1st quarter 2020!) leads to emotions like panic, pessimism, anger and perhaps the desire to take drastic action—and potential pitfalls to follow!
These investments may not be tapped for 10-20 years down the road, but we still feel the emotions behind investment performance, even when—on a rational level—we know it is a marathon, not a sprint to achieve desired returns. There are several behaviors that affect our financial decision making and, it is wise to be aware of them.
Pitfall #1: Mental Accounting
Mental accounting is when we categorize our money into different pots of differing perceptive value, even though the value of the money is the same, regardless of where it came from.
Money that we earn ourselves, our own “hard-earned money” may feel more valuable to us than money that is given to us as a gift, is inherited, or is won in a gamble. For these reasons, you might see someone who wins $1000 at a casino become even more aggressive with the winnings, only to eventually end up with nothing, but they are much less broken up about losing this $1,000 than someone who just lost that same $1,000 gambling from their paycheck. For these same reasons, an investor may be overly conservative about investing their earned money but be very aggressive about investing an inheritance.
Pitfall #2: Confirmation Bias
We all have certain belief systems and will seek out information that confirms these beliefs, often at the expense of evaluating information that does not support or that contradicts these values. This is an underlying human behavior called Confirmation Bias that can be particularly hazardous in the world of investing. An example might be to look only for reports and news that supports the purchase of a particular stock, only to ignore warnings against it. When your money is on the line, it is important to maintain objectivity when evaluating any investment or philosophy!
Pitfall #3: Overconfidence
Overconfidence that you can “beat the street” and forecast returns or growth rates on securities or companies may lead investors down the wrong path. Oftentimes a do-it-yourself investor can fall prey to overconfidence, which can lead to other faulty strategies. The most common is selling investments when the markets are falling to cut losses—not because the investments are bad, but because they are subjected to unavoidable systematic risk of the markets and panic sets in.
Another pitfall is to “chase gains” and buy investments that have recently had big gains in value at high prices, only to be subjected to a cyclical downturn for these investments soon after the purchase. These emotional reactive behaviors result in far less gains than those received by investors who stay the course over the long term.
Pitfall #4: Following the herd
Herding is another behavior where we do not want to go out on a limb because if we are wrong there is a loss of reputation, but if we stay with the crowd and they are wrong, no damage done. An example might be that, because the talking heads on investment TV shows are talking up a company, and my friends are buying stock in that company, than it would be foolish for me to not buy that stock. We want a “piece of the action.”
An example might be the feeling that I need to buy TESLA stock or bitcoin because so many people are talking about them, but not fully understanding why I should buy them.
A more dangerous example of herding (and chasing gains) might be those that jumped in late to buy Game Stop stock recently when it was going up rapidly because their DIY investor friends were doing it, only to be left holding the bag when the short squeeze bubble burst!
Pitfall #5: Taking mental shortcuts (heuristics)
Heuristics is when we take short cuts in our decision-making process and do not do our homework. Here we discuss 3 components of heuristics: representativeness, availability, and anchoring.
Representativeness is when we make decisions based on similar things that have happened in the past. There is the saying: “Those that don’t learn from history are doomed to repeat it.” Understanding why something happened in the past, say the profits of a particular company in a particular situation, may lead to a more profitable investment decision than just trying to copy or mimic yesterday’s news.
Availability is where we decide based on only recent news and events and do not consider long-term history. An example of this is buying only growth stocks because they have outperformed value stocks in the past three years, whereas in the past twenty years value stocks have generally performed better over the long haul.
Anchoring is where we make investment decisions based on a specific price. An example might be to sell one’s house when it attains a certain value, only to have that value more than double ten years later.
How a financial advisor supports your rationality
These and other emotional decisions can lead us off the path of sound investing. Partnering with an informed, objective, and fiduciary financial advisor can help a person stay on the right path and make rational decisions instead of emotional ones as we save for retirement. For more information on how we can help you please visit us at www.f5fp.com, or schedule a free consultation here.
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