Don't Be Your Own Worst Enemy
One of the most well-known investors of the 20th Century, Benjamin Graham, said, “the investor’s chief problem – and even his worst enemy – is likely to be himself.” What Graham understood – and modern research is catching up to – is the idea that we all have emotions and biases that affect our decision-making.
We must always consider these biases when discussing gyrations in the markets. A few of the biases that can adversely impact sound investment decision-making are:
Prediction Fallacy – Humans have an innate desire to recognize patterns and apply these patterns to predict the future. We erroneously believe that because “A” occurred and “B” happened, if “A” happens again, we can profit by anticipating that “B” will repeat. Market history is littered with examples of “rules of thumb” that have worked, until they no longer did.
Selective Memory – Human nature is such that we tend to recast history in the manner that emphasizes our successes and downplays our failures. As a result, we may not benefit from the valuable lessons failure can teach. Indeed, failure may be your most-valuable asset.
Overconfidence – Peter Bernstein, a noted economic historian, argued that the riskiest moment may be when we feel that we are right. It is at that precise moment that we tend to disregard all information that may conflict with our beliefs, setting ourselves up for investment surprise.
Fear and Greed – These are the two most-powerful emotions that move investors and investment markets. Each emotion clouds our capability for rational and dispassionate decision-making. They are the emotions that lead us to believe that prices may continue to rise (think the tulip price bubble of 1636) or that everything has gone so wrong that prices may not recover (think the credit crisis of 2008-2009).
To protect yourself from falling prey to these biases, so you can make better financial decisions:
- Frame performance in a more meaningful way. Look beyond short-term outcomes when framing performance. Think about your longer-term goals and the progress you are making towards them, even when short-term corrections slow your progress.
- Neutralize your recency bias. The human brain remembers recent events more clearly and gives them outsized weight when making decisions. Your brain can mislead you by expecting more of what you’ve seen, and that can lead to overconfidence. Resist this tendency by remembering the market is constantly changing. In time, every bull market ends and every bear market recovers.
- Consider multiple perspectives. With decision making, it’s natural to focus on one aspect or one piece of information as a starting point. Often, that can greatly influence your final choice. This is known as “anchoring bias,” which can give you tunnel vision. It can lead you to fixate on a single data point, like an investment’s price, while ignoring other key information.
- Avoid herd mentality. If you have ever wondered why people continue to invest even when it becomes obvious that a bubble is forming, studies have found it isn't so much that people believe that they are buying into a good investment, but simply that they are afraid that others will make money on the investment and they won't. Many people fear being left out of the possible rewards from the investment much more than they fear actual risks.
- Force emotion into the backseat. Losing money hurts. The pain of losses can actually be more intense than any satisfaction from gains. Economists call that “loss aversion,” and it can can lead to irrational choices that actually work against our big-picture financial goals. Don’t give into fear or panic when they show up. Focus on logic and rely on your professional for guidance.
Financial markets are complex and unpredictable. You can best tap their opportunities to pursue your financial goals when you maintain awareness of the inherent behavioral biases that we all share.
If you find yourself falling prey to emotion, take a deep breath, step back, and consider your long-term goals. In the end, achieving your personal goals is what truly matters.