That’s essentially the takeaway from stacks of research focused on investor behavior. Human nature, it turns out, leads us to make terrible investing decisions. We sell our investments after their value has plummeted. We buy them back when they’re expensive. In short, our inner voice can be self-destructive when it comes to investing.
The irony is that investing is simple. The elements of successful investing begin with determining your goals, implementing well-diversified portfolios based on those goals, and exercising discipline and patience. That last part is where the problems start.
Research has shown that a buy and hold investment portfolio will do better over time than a similar, actively managed portfolio. But whether markets are soaring, plunging or flat, our instincts tell us that it’s better to do something—anything—rather than nothing. Usually, we do the wrong thing.
If it’s any consolation, none of this is your fault. Each of us contains a set of stress responses hardwired by evolution. The same responses that drive you to blow up your investment strategy at precisely the wrong time, helped our species survive and thrive throughout history.
Recency bias is a prime example. If a saber-tooth tiger picked off Ug’s uncle over by the ridge last month, then Ug would probably avoid that ridge in the future. As Ug’s distant relative, you shares his innate recency bias. Except you’re up against the market rather than prehistoric predators.
In modern times, recency bias can make us forget that market conditions change. Many investors in 1999 and 2006 kept loading up on risk, figuring that the market’s terrific recent results would continue indefinitely. Big mistake.
Then there’s herding behavior. Safety in numbers really did apply back when it was man versus nature. But being one of the countless people over allocated to tech stocks in 2000, or real estate in 2007, provided a false and dangerous sense of security.
Confirmation bias is another nemesis of investors. We’re prone to filter out information that contradicts our beliefs. Investing, of course, isn’t about beliefs—it’s about objective facts and figures.
Then there’s the trap of overconfidence. Over-confident investors buy and sell investments ceaselessly, certain that they can outmaneuver and outperform other investors. Spoiler alert: Very few investors succeed at this—including the professionals.
Finally, countless bad decisions are driven by what’s known as loss aversion. Research has shown that humans register loss much more strongly than gains. This can lead us to steer away from risk, even when risks are necessary to achieve our long-term goals.
Adding to the burden of eons-old instincts is the advent of modern technology. Throughout every day, screens of all kind burst with news of threats and opportunities in the market. Selling or buying in response to these cues is as simple as making a few swipes and keystrokes on our handheld devices. When it comes to investing, technology has only enabled the bad behavior that springs from our old instincts.
So what can we do to avoid behavioral traps? One of the best ways to take the emotion out of investing is to work with a good advisor. Such an advisor can help you not only develop an evidence-based long-term plan, but also to stick to it when you’re tempted to make impulsive decisions.
Your advisor will also help you focus on what you can control. Are you overpaying for expensive, actively managed funds that don’t provide an appropriate return? Are your investments tax-managed so that you can keep and compound more wealth over time?
Seeking and acting on good advice can bring you real value, including higher real investment returns. Listening to your inner caveman—or Costanza—won’t.[/fullwidth_text]