“The four most dangerous words in investing are: ‘this time it’s different.'”
– Sir John Templeton
I have a friend who grew up in New England, and I always assumed he liked to ski. Then one day he told me he’d only skied once in his life…
…but it was enough to turn him off skiing for good. Why? He only made it about 20 feet downhill before he flipped over and broke his leg!
That got me thinking. When it comes to investing, we’re a lot like my friend.
Did he wear the right skis? No.
Did he get proper instruction? No.
Doesn’t matter. In his mind, one bad experience with skiing means that skiing will always be bad. In his mind, he’s acting completely rationally.
Turns out he’s exhibiting a classic decision-making bias…one of four that continually plague investors.
Decision-making biases are psychological errors that cloud our judgment. When it comes to investing, these 4 types of bad investing behavior often lead to very poor decisions.
#1 The Anchoring Effect
We tend to rely on our first impression to tell us everything we know. This is known as The Anchoring Effect, and it can cause anyone—including savvy investors—to behave irrationally.
The most commonly used example to demonstrate the Anchoring Effect is the classic ‘It’s On Sale’ dilemma. You’ve probably experienced this one before. You walk into a store, pick out an item, then discover that it’s WAY too expensive. That is, until you realize…it’s on sale! Now you can buy the item guilt free!
First you have to ask yourself; is the item truly worth the cost, even at the sale price? Probably not. But because the initial price was set so much higher, you’ve been anchored to the initial price, believing that the sale price is now a great deal.
That’s a pretty harmless scenario. However, events infused with a ton of emotion—positive or negative—hold greater significance for us. Like my friend’s skiing mishap. Or, like how we all felt watching the market collapse in 2008.
So when we encounter similar situations? No surprise—similar emotions come attached.
When the markets take a dip, do you feel the urge to sell? That’s probably because you’re anchored to seeing your investments at a certain level. But what if the market has been overpriced, and the drop is just a necessary correction?
Suddenly selling doesn’t seem like such a good idea.
It works in the other direction too. Maybe you once purchased a stock while it was skyrocketing, and it just kept going up. What a great feeling!
It’s true, there are a lot of great strategies for investing while the market is high—but following your gut isn’t one of them. You could find yourself buying stocks at their peak and then watching them drop in value.
As investors, letting ourselves be anchored to first impressions can cloud our judgment, and can subsequently lead to poor long-term investment returns.
#2 The Gambler’s Fallacy
Let’s face it. We’re hard-wired to try to predict the future.
The weather. Sports. Presidential elections.
No different when it comes to investing, right?
Unfortunately, we’re pretty terrible fortune tellers. On one notorious night in 1913, gamblers at the Casino de Monte-Carlo huddled around the craps table and watched, stupefied, as the ball landed on black 26 times in a row.
Smarter players might have quit, but they kept on betting, certain that with every roll of black, a roll of red was becoming more and more probable. They lost millions.
This gave rise to the title ‘Monte Carlo’ or ‘Gambler’s’ fallacy, which can be summed up like this:
Just because it has happened before, doesn’t mean it will happen again. Or, just because it hasn’t happened yet, doesn’t mean it’s going to.
Want to know why the Prospectus always says, ‘Past performance is no prediction of future results’? Because it isn’t!
That’s why taking control of the things we can influence—like savings level and diversification—are far more important than trying to guess when the next market crash will happen.
That doesn’t stop us from trying to see the future, though. And that’s the problem.
Erroneously believing that what’s gone up will continue to go up, or what’s dropped will continue to drop, can kill your investment strategy.
#3 Confirmation Bias
We’d like to think that we form our beliefs after we’ve analyzed and assessed the facts.
Turns out, most of the time we do the opposite.
We form our beliefs first, then look for ways to justify and rationalize them. Or, once we find information that affirms our belief, we close ourselves off to information that might challenge this belief.
Sound familiar? It’s called Confirmation Bias, and it happens all the time.
Investors are no different. Confirmation bias can be dangerous, especially when it comes to investing. Here’s why…
There probably isn’t any belief that doesn’t have the “data” out there to justify it.
Do you have a hunch that the Iranian Rial—one of the world’s most worthless currencies—might increase by a HUNDREDFOLD overnight? There are hundreds of analysts, news sources, and politicians that would disagree with you.
But I bet that if you look deep enough, you can find arguments to support that hunch.
Now imagine the Anchoring Affect and Confirmation Bias working together…
Suppose your portfolio took a major hit during the last recession. Then you read an article claiming that another market crash is looming.
Might have you pretty worried, huh? A common reaction to this—unfortunately—fairly common scenario?
To look for other articles that support this claim to verify its accuracy.
Not so fast!
That’s classic confirmation bias. Instead, consider the original source of the information, and what their motives may be (or may not be) for publishing said info. Then compare it to sources that you trust, and if they disagree, weigh the arguments.
Don’t work backwards. If you’re considering an investment decision, start with information from multiple trusted, impartial sources before coming to a conclusion. And don’t be afraid to be wrong!
#4 Herd Mentality
Ever visited a cattle ranch? I have. There’s a reason we call the desire for social conformity a Herd Mentality.
Social conformity is a powerful force which drives people to fit in. In nature there are very good reasons for this.
Safety in numbers, for one. Predators want to break the herd apart, so staying together is a critical survival mechanism.
It goes even deeper than you may think. A study at the University of Leeds asked 100 people to walk randomly around a large hall, without communicating with each other. Within that group, 5 people were given instructions on where to walk within the hall.
In no time the random participants were following the instructed participants wherever they went…without ever having spoken or communicated with each other at all!
And the craziest thing? Most participants didn’t even realize they were following someone else!
But what if everyone is wrong?
That’s the problem with the herd mentality when it comes to investing. Especially at market highs and lows; the herd is either pouring money in, or running for the exits. We seek comfort in the herd mentality whenever we sense danger.
Exactly when following the herd could spell disaster.
Like each of the bad investor behaviors we’ve talked about, the herd mentality is all about an assumption—a bias—that either you believe you know more than you actually do, or that someone else does.
Don’t fall into this trap. Do your own research, come to your own conclusions, and don’t let the herd mentality control your portfolio.
“The stock market is filled with individuals who know the price of everything, but the value of nothing.
– Phillip Fisher
Want to know the easiest, most effective way to overcome every single one of these biases? Simple—learn to recognize them for what they are…and seek guidance from a professional!
Want some help with your overall financial plan? Go to http://doingmoneyright.com/confidenceboostercall to set up your FREE, one-on-one, Confidence Booster Call. Byron W. Ellis, CFP®, CLU®, ChFC®, CRPC®, is a CERTIFIED FINANCIAL PLANNER™ professional and Managing Director of United Capital Financial Advisors, LLC, a Financial Life Management firm. The information contained in this article is intended for information only is not a recommendation, and should not be considered investment advice. Any references to any specific commercial product, process, or service, or the use of any trade, firm or corporation name is for the information and convenience of the public, and does not constitute endorsement, or favoring by United Capital. Please contact your financial advisor with questions about your specific needs and circumstances. The opinions expressed herein are those of Byron Ellis and not necessarily those of United Capital Financial Advisors, LLC. © Byron Ellis