Forbes Councils Member
COUNCIL POST| Membership (fee-based)
May 2, 2024,07:00am EDT
Investing can be exciting and rewarding, but it can also be fraught with psychological pitfalls and emotional detours. While charts and numbers play a pivotal role, it’s important to recognize that your financial journey is impacted by behavioral biases that lurk beneath the surface of your investment decisions.
Behavioral finance dispels the myth of market efficiency, revealing how our human flaws give rise to systematic errors in judgment.
Below, I’ll discuss some of the top behavioral biases that can potentially derail your investment goals and then share tips for not letting your emotions run the show.
Top Behavioral Biases Of Investors
1. Overconfidence: People often overestimate their ability and that of market strategists to make accurate near-term forecasts. This can lead to hasty short-term allocation decisions and excessive trading.
2. Recency Bias: Investors tend to give undue weight to recent information in their decision-making framework. This can result in overreacting to news flow and chasing the latest trend, rather than adhering to a sound investment strategy rooted in long-term principles.
3. Anchoring: Investors often cling to readily available information, such as analyst forecasts, and use them as anchors, making it challenging to objectively assess new data.
4. Confirmation Bias: People actively seek evidence that supports their preconceived opinions, which can lead to subjective decision making.
5. Loss Aversion: Human psychology is wired to feel losses more acutely than gains. This bias leads investors to cling to losing investments, hoping for a miraculous turnaround, while readily letting go of winners to avoid potential losses.
Examples Of Biases In Action
The market outlook for 2023 illustrates the impact of these biases. At the end of 2022, market strategists predicted that stocks would perform poorly the following year, suggesting that the negative momentum seen in 2022 would persist into 2023. This consensus view likely influenced at least some investors to trim their stock holdings, driven by their overconfidence bias in believing that these forecasts were directionally accurate.
Both the market prognosticators and individual investors were likely influenced by anchoring to the prevailing market sentiment and the recency effect following the financial market downturn of 2022. This negative sentiment and gloomy predictions led to loss aversion, prompting investors to park their money in safe assets such as money market funds while awaiting an all-clear signal.
Ironically, as the year progressed, the S&P 500 defied expectations by surging 26.3%. In hindsight, it became clear that these investment decisions, influenced by biases such as overconfidence, recency and anchoring, had proven to be suboptimal, underscoring how behavioral biases can lead investors astray.
Another example of recency bias is from the Federal Reserve and investors who assumed that the pickup in inflation above the Fed target of 2.0% in the middle of 2021 was transitory. Many market participants were anchored to inflation readings that were persistently below the Fed’s target for the past decade, which caused them to miss significant changes that occurred during the pandemic including to the labor market, supply chains and stimulus that had the effect of changing the inflation environment.
The failure to accurately assess incoming information led to policy being too easy for too long, and investors that were not positioned well for a sharp rise in interest rates in 2022 once it became apparent that the surge in inflation was not transitory.
Unfortunately, these types of examples are not uncommon. According to data from JPMorgan Asset Management and Dalbar, the average investor significantly lags broad market indices. From 2002 to 2021, the average investor returned just 3.6% per year, compared to the S&P 500’s 9.5% and a 60/40 portfolio’s 7.4%. The primary reason for this underperformance over time is the impact of behavioral biases on decision making.
Navigating Emotions While Investing
So, how can you harness the power of behavioral finance to become better investors? Here are some key take-aways:
• Acknowledge Your Biases: The first step in mitigating their impact is awareness. Identify your personal risk tolerance, and analyze past investment decisions.
• Embrace A Long-Term Mindset: Avoid chasing short-term gains or panicking during market downturns. Focus on your long-term financial goals, and stick to your plan, even when emotions threaten to steer you off course.
• Automate Your Investments: Setting up automatic contributions and rebalancing strategies helps counteract emotional impulses and keeps you on track.
• Educate Yourself: Learn more about behavioral biases and how financial markets work. The more knowledge you acquire, the better equipped you are to make informed decisions.
There are a number of good resources for people looking to learn more about behavioral finance. For the layperson, a good read is The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness by Morgan Housel. For a more sophisticated audience or people looking for a deep understanding, there’s Personal Benchmark: Integrating Behavioral Finance and Investment Management by Chuck Widger and Daniel Crosby.
Remember that while the market may have a target, your financial journey is unique. By uncovering your own behavioral biases and adopting deliberate investment habits, you can tame the turbulent world of investing from an emotional roller coaster into a path toward a secure and fulfilling financial future. Review your financial plan periodically and reach out to your financial advisor to assess your progress and gain valuable insights into optimizing your investment strategy.
Past performance is no guarantee of future performance. No investment strategy can guarantee a profit or protect against a loss. For more information and important disclosures, please visit: https://sa.nm.com/
Source: https://www.forbes.com/councils/forbesfinancecouncil/2024/05/02/mind-over-money-how-behavioral-finance-shapes-investment-decisions/