This last week has been very emotional for some investors with a stock market correction that included the largest drop on the Dow Jones, in one day ever, by more then 1,000 points. This often leads to financial advisors getting phone calls from their clients concerned about their portfolios. Prudent advisors have already had these conversations with clients. If a portfolio is structured properly, and clients are well-informed and invested in their own portfolios, then there was little cause for concern. Most investors understand the fluctuations and are in it for the long term. Time absorbs these blips for the most part. Markets are cyclical. They will continue to go up and they will go down.
But for some, life gets in the way.
We are psychological beings. Often feelings and emotions can often conflict with logical investor thought. One of the most difficult parts of investing is removing emotions from the equation and relying strictly on rational decision-making. Unfortunately, even our own human brains may sometimes point us in the wrong direction.
When it comes to critical thinking, reasoning, comprehension and strategy, the human brain can handle a massive amount of capacity. However, from a biological standpoint, our brain is limited to some extent by its physical size. To make up for the fact that there is a physical limitation on how much information we can store and process at a single time, humans have developed many cognitive shortcuts that help us along the way.
These shortcuts may have helped our ancestors conquer the world, and they may still help us safely navigate city streets to this day. On the other hand, some of these cognitive shortcuts can lead to costly investing mistakes.
Representativeness
Representativeness bias is a mental shortcut that we use to deal with large amounts of unique information. Instead of analyzing everything individually, we tend to group similar items together in categories and make generalizations about each. For example, a person with a peanut, walnut, pecan, and cashew allergy will likely know better than to sample a new type of nut. Even though that person may have never tried the new nut before, he or she can draw conclusions based on experiences with similar nuts.
While they may often work in day-to-day life, generalizations born from representativeness bias are often useless when it comes to investing. The devil is almost always in the details.
As to investing, there are clear differences between companies, even when they are direct competitors. The strategy and culture of a company are a direct result of each company’s leadership. So even companies that look identical, such as West Jet and Air Canada, can have very different financial results. Investors also tend to unwisely group investments together that share similar brands, such as Facebook and Twitter.
What’s important is to distinguish between a great investment – which is a great business at a fair valuation – and just a great business, which is a similarly successful company with great business fundamentals that is trading at a valuation that is too high.
Anchoring
First impressions are overly important in people’s minds because of what is known as anchoring bias. Once an investor has a certain experience with an investment, positive or negative thoughts about that investment can be hard to shake. For example, if an investor buys an investment that subsequently gains 25 percent in the following six months, the investor may continue to see the investment as a winner.
Investors often make two types of costly mistakes because they remain loyal to investments that made a good first impression. The first mistake is riding your winners for too long or not selling in time. The second mistake is falling in love with a losing position. The latter is more problematic since the loss is taken from the position’s initial capital and not from its winnings.
Investors can help combat anchoring bias by consulting a financial advisor to get an impartial third-party opinion on an investment.
Confirmation
Confirmation bias is essentially mental stubbornness. Once we form a belief about something, we have a natural tendency to seek out information that supports that belief and ignore information that conflicts with it.
Confirmation bias is the reason parents always seem to think their son or daughter is the best player on every sports team or the smartest kid in each class. In the parents’ minds, they see their child as the best. Therefore, they pay attention to all their child’s accomplishments and ignore shortcomings and failures.
Unfortunately, investors can have the same attitude.
It is human nature to seek out information in any situation to support your personal theories, be that in science, shopping or even investing. Successful investors tend to look for evidence that both supports and refutes their original theories, make their assessments objectively and then monitor what is happening from there.
It’s very difficult to overcome tendencies that are hard-wired into our way of thinking. However, the first step in neutralizing these potentially harmful investing biases is to recognize they exist and understand they are most certainly influencing all investing decisions on some level.
Bottomline
Emotional investing occurs when investors make drastic decisions about their money and assets based on a feeling of how the market is performing rather than how the market is likely to perform long term.
When it comes to investing, emotions are best left at the door. Fear, greed, and other emotional signals from the amygdala part of your brain, can easily derail even the best-laid investing plans. That is easy to say but more difficult to achieve personally. That’s why many investors work with a financial advisor. They are the gatekeeper, if you will, the ones who will discuss your investment decisions with you. Prudent advisors ensure you are removing the emotions from your investments and assist in making rational and efficient decisions. They are tasked with Keeping Life Current.