Whenever the market is in a bit of turmoil, it’s important to revisit some of the common behavioral mistakes that can potentially derail even the most well thought out financial plans. Below I discuss six mistakes that we should all look to avoid.
Fear and panic: Perhaps the most costly and pervasive of all behavioral mistakes, fear and panic is generally characterized by feelings like “I am getting out until things calm down”, “I can’t take it anymore” and “Maybe the markets just aren’t for me.” An example of this mistake would be an investor who abandoned a long-term investment portfolio amidst the financial crisis of 2008, participating fully in the market decline, but completely missing out on the rapid market recovery during the next three years.
Greed and euphoria: The opposite of fear and panic, this is when an investor sees an investment that is going well and subsequently disregards any risk of loss by going “all-in”. An example of this mistake would be an investor who abandoned a diversified portfolio in favor of a portfolio of dot-com stocks back in 1999 or “spec” houses in South Florida in late 2005.
Regret: This mistake gives the investor the unsettling feeling that “I should have seen it coming.” Examples of regret might include “If only I had sold everything before the market crash”, or “Why didn’t I buy more of that stock that doubled in value?” The problem with regret when it comes to investing is that we don’t know the future, so we must make decisions in the context of what we know at the time. A decision to bet your life savings on the spin of a roulette wheel is a bad decision regardless of the outcome.
Overconfidence: A surprisingly common behavioral mistake, overconfidence is characterized by the notion that one is, in fact, capable of predicting the future. An overconfident investor may make remarks such as “I just know that the market is going down” or “This is a ‘can’t lose’ investment”. Anyone who claims to know the unknowable should not be relied upon for investment advice.
Mental accounting: As Nick Murray describes in his book Simple Wealth, Inevitable Wealth, mental accounting is like “asking your investments to behave differently because of what you paid for them.” One example of this practice is when an investor hangs on to an investment just to get back to even, even if there is no longer a rationale for owning it. With the exception of tax considerations, the amount paid for an investment should be ignored when making investment decisions.
Herding: With this mistake, an investor gets that feeling that “everyone is getting rich but me”. As a result, there is a tendency to follow the crowd regardless of whether or not it is a good idea or appropriate for their situation. One example might be the feeling that may have overcome a renter during the housing price run-up of the mid-2000s. The feeling that homeowners were getting rich off their homes may have encouraged a renter to purchase a home even if it was unaffordable. Investors are generally better off avoiding the herd and sticking to a plan that is well suited to their particular situation.
This is just a sample of the many behavioral mistakes in investing, but there are many more. The consequences of making these mistakes are potentially life-altering, so avoiding them is crucial. To steer clear of these mistakes, we suggest the following: define your objectives, develop a well-thought investment plan designed to meet those objectives, adhere to an investment philosophy that is evidenced based, avoid the noise of the media, and focus on what you can control. This is easier said than done, so for most of us, that means hiring a competent and empathetic advisor who can help keep you on track.