Is your mind playing tricks on you when it comes to investing?
It’s no secret that everyone should be investing for the future. Even if you’re extremely risk-averse, investing your savings in stable investments like exchange-traded funds (ETFs) or bonds will likely yield significantly higher returns than stashing your money away in a bank account. But there are risks to investing that don’t just stem from natural market fluctuations. A recent study by Charles Schwab revealed that over the past year, advisors have noticed an uptick in behavioral biases when it comes to their clients’ investment strategies. There are, then, psychological underpinnings to your investment pitfalls.
It’s not a huge surprise. With investment developments like the rise of meme stocks, more people are looking to their investments as a way to get rich quick. While these kinds of mindsets pay off for some, they can have financially devastating consequences for others. That’s why it’s a good idea to take a step back and critically examine how behavioral instincts may be affecting your approach to investing. A financial advisor may also be able to help, so consider using SmartAsset’s free advisor matching tool to find qualified advisors who work in your area.
Behavioral Biases By the Numbers
Conceptually, it’s easy to take a look at behavioral economic concepts and dismiss them as rookie mistakes, or even mistakes that you wouldn’t make yourself. However, the proof is in the numbers. The results of the recently released Charles Schwab study about how behavioral biases are impacting client portfolio performance are striking.
Over the past several years, Charles Schwab has has its advisors measure behavioral investing biases that they see in their clients. Between 2019 and 2020, advisors reported an average fluctuation in behavioral biases of just 3%, with some biases increasing and some decreasing. However, in 2021, advisors reported an 18% increase in behavioral biases on average.
Certain biases stood out more than others. Recency bias, one that causes people to favor recent events over historical trends, grew 58% in 2021 – a 35% increase from the prior year. Confirmation bias, a tendency to recall information in a way that suits your preferences, and framing, which influences choice based on surrounding data, both increased more than 25% from the previous year.
What Are Behavioral Biases in Investing?
Behavioral biases are common in life and in investing. One of the most common is the hot hand fallacy, or recency bias. Let’s say you make three great but risky stock picks in a row. Many people, from that data, will infer that they’re extremely talented investors and will go out and make more risky stock picking decisions, thinking that they’re bound to repeat their past successes.
However, past performance isn’t necessarily indicative of future success. While it’s certainly a good thing that you were able to make three great stock decisions, you shouldn’t assume that you’ll be able to make three more. That type of mindset often leads people to make riskier and risker decisions to try and build on that success, and it often doesn’t yield the same results. You could wipe out the gains you made, or even go net negative.
Examples like these are common in the world of finance and investing. Another is what’s called prospect theory. Someone who has lost $1,000 at a casino over the course of a night is far more likely to double down and place bigger and bigger bets to make up for his losses, even though he’s likely to compound those losses.
In an investing context, someone who has lost money on a particular investment is more likely to stick with that investment or even buy more, hoping to make up for their initial losses. While this kind of tactic may lead to future gains, it just as well could lead to you sinking more money into a losing investment.
Why Has Behavioral Bias Increased?
If there’s one factor that ties together the events of the past two years, it’s the COVID-19 pandemic. The drastic market downturn and subsequent market recovery have made investment markets as frothy as ever. While millions aren’t able to afford basic necessities, many are making boatloads of money in the stock market and real estate markets, leading to market conditions that defy traditional history.
Interest in retail investing has also skyrocketed, especially since the GameStop short squeeze events of January 2021 and beyond. More people than ever are investing through online brokerages and apps like Robinhood, leading to other market inefficiencies that many are capitalizing upon.
In the vast majority of instances, being a successful investor requires taking a long-term approach. While it’s true that anyone can take advantage of a market inefficiency and see huge payouts immediately, not everyone can take advantage of a market inefficiency and see huge payouts immediately. Nonetheless, it’s an attractive idea and has led to a big increase in behavioral biases as people try and take shortcuts to massive returns.
How Can You Protect Yourself and Your Assets?
Almost all of us are subject to the instincts that cause behavioral biases to thrive. When you buy a stock and it immediately shoots up by 15%, it’s easy to believe that you possess an innate ability to replicate that pick again and again. But even if you truly are one of the best investors out there, it’s important to recognize that past results aren’t indicative of future success. You shouldn’t shy away from a rational investment strategy because of a few outliers.
During a market downturn, it’s common for investors to panic and sell their investments at a fraction of what they were purchased for. However, if you’re a long term investor, being able to recognize market trends and weather the storm is a valuable skill that can keep your investment portfolio healthy over the long term. It’s natural to have the behavioral instinct that is recency bias, but being able to overcome that instinct and view it objectively is the rational decision.
Ultimately, the way to protect yourself against behavioral biases in investing is to be aware that they exist. Instinct is one thing that we all possess as humans. However, putting those instincts in context can keep you from making irrational decisions. As scary as a market downturn can be, don’t stray away from rational investing approaches. Your financial advisor may be able to help you contextualize your investment decisions and keep you on a steady path as well.
Tips for Investing
- Investing isn’t always the easiest task. From deciding which investments to pick to dealing with behavioral biases, there’s a lot to think through. A financial advisor may be able to help. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor, get started now.
- If you’re investing on your own, it’s a good idea to be well prepared for what the market can throw at you. SmartAsset has you covered, with a number of different online resources you can use to make smarter financial decisions. For example, check out our investment calculator today.
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