No matter how intelligent, educated, or successful you are professional, you might not always make the best choices when it comes to investing.
This is due to the fact that, as a human, you are hardwired to act in certain ways that, while helpful in many aspects of your life, tend to work against you when it comes to making wise financial decisions, claims psychologist Daniel Crosby, author of The Behavioral Investor.
High intelligence might even be a warning sign, according to Crosby: “Not only is it not an insulation [against making poor financial decisions].
However, there is a catch: Being aware of your mediocrity in the markets can actually make you a better investor.
Investors are prone to four ingrained biases, according to Crosby, who based his claim on decades of groundbreaking behavioral research. You can, however, take action to either lessen their impact or use them to your financial advantage if you are aware of them.
Each person has an ego. It shields us in a variety of ways, including by fostering a sense of self-assurance in our skills and judgments, which is frequently mistaken for overconfidence.
People who develop a strong sense of self-assurance are more likely to be resilient and succeed in their careers. People who are overconfident are frequently happier and more successful in business and politics. And a robust ego can protect us from setbacks, disappointment, and loss, the speaker added.
However, having too much self-confidence when it comes to investing can actually cost you money.
Crosby cited the example of how most people prefer to find information that supports their existing beliefs over information that challenges them. He cited studies that demonstrated how, due to our ego, we may grow even more firmly rooted in our false beliefs, even when those facts are in direct opposition to what we already believe.
When investing, this could have the effect of making you confident that a particular business or emerging asset class, such as cryptocurrency, will succeed in the future. You therefore invest a disproportionately large sum of money in your winning concept.
However, research indicates that investing in a smaller portion of the market in favor of picking the stocks you think will perform well, in the long run, may reduce your returns. According to statistics cited by Crosby, over five and ten years, active stock fund management outperformed passive indexing more often than not (more than 80% of the time). Even without taking into account the higher fees an investor pays for actively managed funds, that is.
Investing always involves risk. However, people’s desire to stick with what they know or their willingness to go too far with the proverb “invest in what you know” can actually raise that risk.
Crosby gave the example of a tech worker who purchases a home in a major tech city like San Francisco and invests mainly in tech stocks. The net result is that because she invests the majority of her time and money in the tech industry through her job, her property, and her portfolio, the sector’s health will have a disproportionately large impact on her financial prospects. She might suffer financially if the tech industry suffers.
Another way that investors frequently opt for the known is by concentrating their investments in US stocks because they think that non-US stocks are too risky.
Bias in attention
People frequently focus excessively on negative information or high-stress, low-probability events (e.g., shark attacks or planes flying into buildings). Both can skew how we perceive risk.
Furthermore, Crosby pointed out that information overload, whether it be from data, research, or news, can result in poor decisions because it is difficult to distinguish between the forest and the trees when there is an abundance of information.
In some challenging circumstances, our feelings and intuition can serve as a form of protection or guidance. After dating people who weren’t quite right for you for years, you might finally choose a good partner.
However, they can also make us act impulsively in the heat of the moment and disregard what we would normally do.
Consider donuts, Crosby advised. Despite receiving the best nutritional counseling possible, when stress levels are at their highest, people always reach for the powdered donuts rather than the asparagus.
The impact of emotion on the markets can be expensive. When your fear is active, you might panic and make the wrong purchase. Or, if you’re overjoyed, your optimism may cloud your perception of the actual level of risk involved in an investment.
Techniques for overcoming our biases
Investors can try to overcome their ingrained biases in a variety of ways, according to Crosby. His suggested tactics include:
mute the clamor. Don’t frequently check your investment accounts. Don’t get caught up in every market gyration. Avoid getting swept up in metrics. Additionally, avoid letting unbalanced negative events influence your investment choices.
Possess humility. Future events cannot be foreseen. Additionally, you’ll never have enough information to make a sure bet on a particular stock or industry.
Spread out your holdings. According to Crosby, managing ego risk is embodied by diversification, as stated in his book. It’s a clear acknowledgment of the chance and ambiguity involved in managing money, as well as a recognition that the future is unpredictable.
For instance, Crosby suggested that you shouldn’t invest significantly more in domestic stocks than their share of the global market to combat the so-called home bias in your investments. Depending on how they are calculated, US stocks make up anywhere between 45% and 60% of the world’s equity market. However, the majority of equity holdings of typical US investors are usually concentrated in US firms, with very little of their portfolios consisting of foreign stocks.
Establish a system. Regardless of market conditions, automating your savings and investing across a diverse portfolio frequently works well. The same is true for saving money on a regular basis for short-term objectives and unexpected expenses.
Retirement savings are one area where the “set it and forget it” principle is used. Employees who opt to have their 401(k) plan automatically increase their savings whenever they receive a raise fare better than those who must decide how much to save each month.
When low-income parents have an envelope designated for savings with a picture of their children on it, they are more likely to save twice as much money, according to a study Crosby cited.
Recognize that no investment is flawless. Through their 401(k)s, many people gain access to the stock market, particularly through the target date funds that their employers provide as the default investment.
Even though target date funds have detractors, according to Crosby, “Every investment is flawed. And [target date funds] are far superior to what the average person is doing for them.