Saturday, December 26, 2015

5 common mistakes

In this series I will discuss the five most common mistakes investors make, and what you can do to avoid them. With a stronger understanding of behavioral finance and these errors, you will be in a better equipped to avoid them!

Overreaction/availability bias. What is it? In financial terms, overreaction is the tendency to react in the right direction—but excessively so. It’s the Rumors Run Wild investing equivalent of someone getting upset at something small and losing his temper completely. An example would be an investor who pulls out of the stock market completely at the first sign of bad news. Overreaction is usually related to availability bias, which means overestimating the probability of more recent, memorable events that you observed personally. An example is an investor putting too much weight on recent negative information instead of the big picture. When both biases are combined, many investors make the situation even worse by going all in because the market is doing well (and usually at its peak), and going all out when the market is doing poorly (the best time to buy!). To counteract these tendencies, understand that you may have information that is correct, but not complete. Instead of relying on only what you know, add in the missing pieces to put things in a larger context. This can help mitigate the tendency to react too strongly in either direction.

Focusing on short-term performance. We all know that focusing on the long-term is the key to success, but we can’t help but overreact to short-term performance. That’s because we tend to overweight the importance of whatever’s going on right now. Simply put, we’re wired to be short-term thinkers, and overcoming that tendency is a difficult—but not impossible—task. The pain we feel of losing something today is greater than gaining something in the future. It doesn’t help that the media bombards us with short-term developments in the markets. When this happens, we want to step back and understand investors with a long-term frame of mind are rewarded. You want to focus on your goals, not performance. A goals-based financial plan is the financial foundation for everything else. If your goals or time horizon hasn’t changed, then there is no reason to change your asset allocation. This one of the main reasons to use a financial planner, who can reassure you and keep you on track.

Following the herd. The average investor usually follows other investors. If there is a sudden rush into a hot sector such as tech, then a herd investor will follow suit even if the lemmings sector is clearly overpriced. This is what happened in the dot-com bubble of the early 2000s. Herd behavior can have disastrous effects when an investor buys when the market is high and then in a panic sells when the market starts going down. Why do people follow the herd? Because psychologically, it gives you a sense of security that everyone else is doing it. That is why testimonials, word of mouth referrals, and social proof are very powerful. In order to counteract this behavior, find out the root cause. Is it because you don’t want to appear foolish and left out? Is it because of peer pressure? The key is to know the true value of the stock, not what people say about it. Most people will never buy a house or car without first finding out what it is worth. However many buy and sells stocks as though the price and value don’t matter. According to research, men (47%) are more likely than women (9%) to follow the herd.

Confirmation bias. Those with a strongly held belief will only look for information that will validate their belief and ignore contradictory information. This habit is known as confirmation bias. People may feel as though they are making an informed and correct decision, but their choice may be skewed by their own biases. For example, you may like a certain investment and pay attention to information that supports your decision (strong recent performance) but gloss over other information (high price-to-earnings ratio) that doesn’t support your decision. What makes this more difficult to deal with is that many of us don’t know that we do this and are more close-minded than we think. One of the things you can do is pretend you are in a debate and argue the opposite side. Research the position contradicting the belief you currently hold so you can be objective as possible. It is important to have the complete picture when making a decision.

Anchoring. People have a tendency to rely on the first piece of information (the anchor) when making decisions, even if the information is not relevant. This is why car salesmen start with a high price, so the buyer judges the value they get based on how far below this price they go, not necessarily what the car is worth. An investor may hang on to a losing stock by waiting for it to break-even at the price they bought it at. The investor is anchoring the value of the investment to the original value, not the actual value of the stock, and thus taking on more risk. To avoid anchoring and using an individual number as a reference point, evaluate investments as if it were a new purchase. Reframe the situation and ask yourself “If I didn’t already own this stock, would I buy it today at is current price? If the answer is no, then you know you are anchoring and need to avoid fixating on the particular reference anchor.

While we may never be able to eliminate our emotionally-driven tendencies, we can reduce the impact by better understanding how we make decisions. Be proactive to avoid these mistakes so you can override negative behavioral tendencies!

-- David Chang, Thinking Smart, Midweek, December 23, 2015

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