Knowing the basics of behavioral finance will help you steer clear of common investing mistakes.
Certain quirks of the human brain can cause us to make less-than-optimal financial decisions. In recent decades, the growing field of behavioral finance has sought to explain why we make the money choices we do. “It has nothing to do with intelligence, and everything to do with biology,” said David Edwards, president and founder of Heron Wealth, an independent advisory firm based in New York. “Ten thousand years ago, humans didn’t have time to do a lot of analysis when judging, say, whether an unknown animal was food or predator; so we are conditioned to make decisions by shortcut all the time.”
That’s why even the most informed investors are susceptible to investing errors. Below are four common money mistakes, and how you can use behavioral finance to resist making them.
There are few ways to lose money faster than by selling a stock at a much lower price than you bought it. So why do people do this so often? Selling low typically happens during a market downturn, as investors panic and sell assets to prevent taking further losses. Behavioral finance identifies this impulse as “loss aversion,” or the fact that humans feel the pain of a loss more strongly than the pleasure of a gain. Once upon a time, high alertness to danger may have protected humans from approaching predators. But in today’s investing, it can distract from the fact that taking short-term losses is an expected part of achieving long-term gains.
TIP: To help combat your tendency toward loss aversion, check your investment balances only once per quarter. If you’re feeling particularly concerned about a period of market volatility or short-term losses, consult your financial adviser for help in putting current events in a broader context.
Purchasing stock after a period of rapid growth can set you up for losses in the near term and a lower return in the long term. But when investors are flocking to a hot market or company, it’s hard not to want to get in on the action. Behavioral finance experts cite this as a case of “herding,” or people’s tendency to follow the behavior of those around them. But the reality is that by the time you jump in, stock prices are often overvalued and possibly headed for a downturn.
TIP: When you notice prices going up for an item at the grocery store, you’re prone to question whether it’s still a fair deal. Give stock prices the same skepticism. Rapid growth of a stock might generate buzz on cable news shows, but all it means is the stock is now a lot more expensive to buy than it was just a few weeks ago. Don’t simply follow the pack into a potentially overpriced investment. Instead, base investment decisions on criteria from your own plan, such as sector diversification.
Not vetting new investments
Whenever you put money in the market, it’s important to be sure the investment fits within your broader finance goals. But many people spring for investments that look good at first blush, and end up hurting their bottom line later. This error, called “confirmation bias,” describes people’s tendency to notice data only, and information that supports a conclusion they’ve already reached. In other words, you see an investing opportunity that looks good and therefore focus only on data that supports that impression, ignoring other data that may serve as a red flag.
TIP: Stick to a system. “Successful investors have rules and discipline,” said Edwards. For any possible investment, make a checklist of factors to assess in addition to the data that piqued your interest. By following a uniform set of rules, you can resist the urge to invest based on gut instinct alone.
It may be impossible to eliminate all emotion-based investing errors, but avoiding the biggest and most common ones is anything but. Basic knowledge of behavioral finance can help you go a long way in controlling harmful impulses and poor decisions. “Once you understand these are normal attributes and fears, you can get a lot better at managing them,” said Randy Kaufman, senior vice president of EMM Wealth, a New York-based wealth management firm. “Behavioral finance shows us how, in a lot of cases, doing something ‘irrational’ with your money doesn’t make you irrational—it makes you human.”