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“Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble… to give way to hope, fear, and greed… The investor’s chief problem and even his worst enemy is likely to be himself.”
– Benjamin Graham, widely recognized as the father of value investing and mentor to Warren Buffet
Economists, professors of personal finance, and mathematicians have developed complex, statistical models to predict how stocks should be valued, how markets should react to changes in the financial, social, and political environment, and how investors should behave. These traditional finance methods were based on the assumption that investors are rational, markets are efficient, and returns are a function of risk. However, in the wake of the technology bubble and the real estate crisis, financial experts have been forced to acknowledge the terrible flaws in these assumptions. Research in the emerging fields of behavioral finance and financial psychology have confirmed what astute financial historians, such as Benjamin Graham, have long recognized: investors are irrational, markets are inefficient, and returns are influenced by emotion and cognitive biases. Cognitive biases and emotional investing are part of the human condition. However, with some insight and fortitude, we can override these natural impulses and rise above our animal brains. What follows is the first of a three part series on common investor mistakes and how to avoid them:
1. Overconfidence. How good of a driver are you? Are you better than average? Chances are you think you are. Eight out of ten people rate themselves as above average behind the wheel. Obviously, this is a statistical impossibility. In terms of investing, men rate themselves as having more financial knowledge and confidence compared to women. Sorry guys, it turns out that women are better investors. On average, women outperform men by 1% annual return. Why? Overconfidence leads to more trading. More trading leads to more fees. More fees leads to lower returns. A healthy dose of self-doubt, second thoughts, and uncertainty is good for your wallet. I know what you’re thinking: overconfidence is bad, but I really am an above average driver better.
2. Reference point fixation. Shortsighted financial decisions can be made when we are fixated on meaningless reference points. The 52-week high or low of a particular holding. The amount of your initial investment versus your current account balance. The DOW Industrial Average in January 2000. A 40% gain in the S&P 500. The price of your house when you bought it. It is easy to get stuck on a particular number and evaluate your holding’s value, profit or loss inaccurately. For example, the 52-week high of a particular holding is meaningless until you compare it to industry averages. By itself, a 20% gain (or loss) in your portfolio tells you nothing about its performance relative to appropriate benchmarks. A 90% gain from the bottom of the market may still represent a 70% loss from the top. Making decisions based on an emotional attachment to a meaningless reference point without careful consideration of the larger context can be dangerous for your financial health.
3. Playing with the house’s money. Financial good fortune, such as selling an investment that made money, having a great year in the stock market, or coming into sudden or unexpected money, can make you lose your head. Research shows that people are more likely to double down after a financial success, even though their odds of winning have not increased. As such, they are at significant risk of taking much more risk than they normal would (or should). If we let our exuberance take the reins, we are much more likely to steer ourselves right off a financial cliff.
Dr. Brad Klontz, Psy.D., CFP®, is a financial psychologist, an Associate Professor and Founder of the Financial Psychology Institute at Creighton University Heider College of Business, a Managing Principal of Occidental Asset Management (OCCAM). and co-author of five books on financial psychology, including Mind Over Money: Overcoming the Money Disorders That Threaten Our Financial Health.
You can follow Dr. Klontz on Twitter at @DrBradKlontz.
Copyright © 2016 by Brad Klontz
