The Top 5 Behavioral Pitfalls of Investing
When you bought the diamond ring to propose to your wife, did you buy the first ring you saw? Or did you shop around until you found the highest quality diamond for the best price from a trustworthy jeweler? Even if you cannot say yes to the second question, you probably have learned the importance of wisdom when it comes to shopping for valuable items.
Now think about your investment portfolio. If everything goes according to plan, your nest egg will fund your adventures post-retirement, help take care of your spouse when you’re gone and will bless mankind in the ways you see fit.
However, there are many stumbling blocks along the way. Recessions, market volatility, unexpected life experiences, and fear sometimes motivate us to make irrational decisions. Investing and irrational decisions don’t mix well.
If you want your investment portfolio to outlast your negative life circumstances, it’s important to be prepared. In this list, we share the top 5 behavioral pitfalls of investing and 5 potential antidotes.
Today, you’ve probably already scrolled through your news feeds and read several eye-catching headlines about the market, certain industries you care about, and the political state of our nation and world. One of them may have even made you think that it is time to change your investment strategy.
Imagine for a moment that you changed something in your investment portfolio every single time you read something that disturbed you. Chances are you would need to adjust your strategy multiple times a day every day! Not to mention, many news stories are overexaggerated or from faulty sources.
Possible Antidote: Sober Assessment of Data
In a digitally connected world, we face an endless barrage of headlines, notifications, and opinions when it comes to investments. Without proper context, the numbers and charts create whatever narrative we want to hear. A sober assessment of data, as well as our own natural behavioral biases, can reduce subjectivity in our investment decisions.
The Bottom Line
Don’t trust the headlines; trust your long-term plan based on a sober assessment of data.
2-Acting on gut feelings
Warren Buffett’s net worth is around $108.4 billion, and even he doesn’t trust his gut feelings when it comes to reacting to the market short term.He says, “I know what markets are going to do over a long period of time: They’re going to go up. But in terms of what’s going to happen in a day or a week or a month or a year even, I’ve never felt that I knew it and I’ve never felt that was important.”
You may watch the markets closely and think that you know when it’s best to buy shares based on a short-term jump in the market. The problem is that these types of decisions are based on gut feelings with FOMO (fear of missing out) being the main driver of your behavior.
Possible Antidote: Put a System in Place
Emotional decision-making is an investor’s worst enemy because it often contradicts sound judgment. When it comes to investing, we must vigilantly guard ourselves against fear and greed. Having a system in place that eliminates these all-too-common tendencies provides a better opportunity to achieve our financial goals.
The Bottom Line
Never make emotional decisions based on short-term changes in the market.
People can panic sell based on short-term drops or spikes in the market. You may be tempted to join them or think that you are foolish to do nothing. But patient people who wait for the market to adjust over the long term and remain focused on wise principles for investing tend to do well when they retire.
For example, in 2008 many people decided to panic sell at the bottom of the market. What happened? According to Forbes:
“Those who held on and said, ‘I’m going to do nothing, I’m going to wait for this to recover,’ may have lost two, three, four, or even five years in some cases, but now over a decade later they have recovered—and then some…”
Possible Antidote: Consult with a Financial Advisor to Capitalize on the Market When Inefficiencies Exist
Investor sentiment is a primary indicator of short-term market performance and it’s no secret that our “feelings” toward portfolios can change daily. This behavioral aspect of investing creates opportunities for rational investors to capitalize when inefficiencies exist within the market. There may be ways to capitalize on the market, but you need to consult with a Financial Advisor to do it right. If you don’t want to consult with a Financial Advisor, it’s best to put your blinders on and let the market correct itself over the long term.
The Bottom Line
When in doubt, wait it out.
4-Underestimating the Risks
When you set up your investment portfolio, you might have chosen high-risk returns. But are you truly risk-tolerant? Higher-risk investments might earn you higher returns over the long term, but you need to understand the balance between risks and returns and what that will look like in short-term situations.
For instance, when the market drops and your portfolio also goes down by tens of thousands of dollars, that might be the first moment that you consider or see the risks. Don’t wait for that moment. Speak with a Financial Advisor about potential risks before they happen and plan how you will react to those risks objectively when the time comes.
Possible Antidote: Identify and Limit the Downside Elements of Volatility
The financial world defines risk in terms of volatility, but its most common metric (standard deviation) treats upside and downside movements equally. The ultimate risk to an investor is loss of principal, and our aim as investors should be to identify and acknowledge the downside elements of volatility when possible. A Financial Advisor will be able to lead you through a pre-established plan on how to identify risks and limit them based on data.
The Bottom Line
Understand the risks involved.
Aimless, impulsive trading in the stock market creates chaotic and sporadic results. When you don’t have a plan, it’s only a matter of time until your emotions take the wheel.
Incorporating a process to the plan reinforces the structure of a long-term plan.
Possible Antidote: Keep a Long-Term Perspective
Investors with a plan and the ability to stick to it have a higher probability of achieving their goals than those who respond emotionally to the events of the day. Sticking to a plan requires a longer-term perspective and a process for executing regardless of the circumstances or market environment.
The Bottom Line
Rely on a plan and trust a professional as adjustments come.
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** Past performance may not be representative of future results. All investments are subject to loss. Forecasts regarding the market or economy are subject to a wide range of possible outcomes. The views presented in this market update may prove to be inaccurate for a variety of factors. These views are as of the date listed above and are subject to change based on changes in fundamental economic or market-related data. Please contact your Financial Advisor in order to complete an updated risk assessment to ensure that your investment allocation is appropriate.