In the field of economics, textbooks portray people as rational beings who make rational investing decisions – homo economicus. But we all know that people are not always rational. Psychological, cognitive and emotional factors impact their behavior and their decisions – and those decisions often result in costly mistakes. Understanding these four behavioral investing mistakes can help us avoid them.
Recency bias: ‘Current trends will continue into the future.’
Many people see what has happened in the recent past and conclude that the same trend will continue indefinitely into the future. A relative newcomer to investing in 2008 may have thought that the market would always be terrible. It was all too common for people to sell their holdings (usually at the very bottom) and stick with cash, assuming that nothing good would happen. Unfortunately, those people missed out when the markets rebounded, which they almost always do.
Overconfidence: ‘I bought Tesla at $100, so I’m obviously an investing whiz.’
Just because you made a good decision once or followed your someone else’s good suggestion doesn’t mean that you (or any of them) have figured out the magic bullet for successful stock picking. There is no magic bullet. A win in the stock market, like a win at the roulette wheel, doesn’t mean you should take out a second mortgage and put it all on your next pick.
Confirmation bias: ‘This fact/article/pundit backs me up, so I’ll ignore everything else.’
Paying attention only to what you believe to be true while ignoring whatever doesn’t support your opinion is a problem because it means that you do not consider outside evidence. This type of bias causes people to dig their heels in rather than being willing to shift their mindset. This is clear in many situations, from political positions to investing. Confirmation bias is often hard to see in ourselves. Imagine a real estate investor who did really well during a housing boom but attributes their success to personal acumen. That investor may remain overly focused on real estate, avoiding other asset classes in spite of the fact that they might be excellent additions to their portfolio. Conversely, a real estate investor who suffered great losses may avoid real estate in the future because of an irrational belief in the notion “once bad, always bad.”
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.