Having trouble dumping a hopeless stock? Keeping money stuffed in a mattress — or 0% CDs — out of fear of loss? You know you’re not alone: making investment decisions with a cool head is a challenge to almost everyone in today’s market. But, you probably also know that when hopes and fears are influencing your choices so significantly, you may not be making the best decisions you could be.
Today’s WSJ explores the challenge of controlling your emotions when making decisions related to investing — and offers a few common psychological pitfalls that the most disciplined investors are better able to avoid.
Anchoring bias, for example, is a form of attachment to an asset that might cause you to hold on to it for too long. If you’re anchored to a particular stock, you might be convinced that the stock’s high point is its “normal” — and that it will eventually return to that level — even in the face of evidence to the contrary. Or, you might also overvalue an information that bolsters that view, while ignoring more relevant negative information.
Similarly, when influenced by a recency bias, you value recent data about an asset more highly than other data — a phenomenon that explains, for example, how homeowners looking to sell can be so reluctant to price their homes at current market levels.
Possibly the most common bias affecting investors is the loss aversion bias. This bias causes us to avoid “locking in our losses” by selling devalued stocks — and keeps us clinging to the hope that they’ll rebound. This bias can be very powerful for many of us, because, psychologically, many of us feel more pain from losses than we feel pleasure from the same amount of gain. Paradoxically, though, actions (or lack of action) driven by loss aversion bias can have a high opportunity cost, since selling floundering stocks could permit reinvesting in assets with more immediate growth potential.
The cure for investment biases? There is no easy solution. But, the Journal recommends discipline, and taking good advice, as good first steps. Investors who stick to data-driven decisions are better able to overcome the negative effects of emotional biases over the long haul. And, those who rely on good advisers for valuing assets — thereby avoiding overconfidence bias — are also armed to make better decisions.
Another step that could help: diversification. Investors who had their entire portfolios invested in the public markets and their primary residences have suffered most of late. Portfolios that were buffered with investments in alternatives that didn’t move with those two markets have done much better. And that extra bit of stability, we would argue, could allow investors to feel more more confident in their diversification strategies, to take the necessary rebalancing steps, and even act now to scoop up market bargains. (Of course, it probably goes without saying that the investments we offer at Sterling Pacific Financial have offered much needed diversification to our investors — and have, in most cases, delivered returns of 10% or more over the past five years.)