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Dollars and Sense: The Psychology Behind Common Investor Mistakes

by AAII

In a perfect world, investors would behave like Star Trek's Mr. Spock, taking in information, calculating probabilities and making the logically "correct" investment decision.

But investors are . . . well . . . only human. And researchers have found a number of common psychological traits and mental mistakes that people often make that results in less-than-rational behavior. An understanding of the psychology of investor mistakes can help you avoid them and improve your own investment results. Here's a rundown of the most common psychological effects, and how you can reduce their impact on your own investment decisions:

Overconfidence: Most people regularly overestimate their abilities, and that applies to investment skills as well. In the same vein, people also tend to overestimate the ability of professional investors.

Overconfidence often leads to excessive trading, whether it be based on your own decisions, or based on the recommendations of a professional stock broker or analyst.

What can you do to avoid this?

First of all, trade less, whether it be in terms of individual stocks, or moving in and out of various mutual funds.

Second, discount the opinions of analysts and other "professionals," who tend to go to extremes, either overly confident or overly pessimistic.

Fear of Regret: One mental error that can affect decision-making is to focus too much on the potential feelings of regret at having made a poor decision. This is rooted in most individuals' dislike for admitting they are wrong. One outcome of this fear is that people will postpone making a decision, since that would "finalize" or "admit" the error. This, in turn, can lead investors into holding onto "losing" investments for too long (not wanting to admit an error), and selling winning investments too quickly (to "finalize" the correctness of the decision and remove the potential for regret if the investment subsequently falls in value).

What should you do to avoid this mental mistake? Don't let the prospect of regret at making a decision that turns out poorly have a disproportionate weight in your decisions. Convince yourself that unrealized losses in your portfolio are the same as realized losses.

Cognitive Dissonance: Most people don't want to hear something that conflicts with what they believe in—they will tend to avoid or discount conflicting beliefs, and seek out support for their own belief. In investing, that can result in investors ignoring bad news about an existing holding.

How can you adjust for the tendency to avoid or deny new, conflicting information? Investment discipline can help—write down the reasons for purchasing your investment, and re-evaluate that reasoning over time as dispassionately as possible. If the fundamental reasons for purchase no longer hold, then admitting a mistake may often be the prudent thing to do.

Anchoring: Another mental mistake investors often make is to place too much emphasis on recent prices or recent performance, which serves as a psychological "anchor" on which later prices or performance are judged. One obvious example is picking a mutual fund simply because it was the most recent period's top-performing fund, rather than paying attention to long-term performance over various time periods and the experience of the individual portfolio manager.

How can you avoid this mental error? Simply be aware of how recent prices and performance can serve as psychological anchors in thought processes, and base your decisions on long-term, thorough analyses.

Representativeness: The brain often likes to take short-cuts, and one that is quite common is the assumption that things sharing similar qualities are quite alike. Sometimes this short-cut can be quite useful, but it can also lead to costly mistakes. The effect of representativeness in investment decisions can be seen when certain shared qualities are used to classify mutual funds. Two funds may be classified as small-cap funds, and both may report poor results, with both being considered "bad" mutual funds. This may not be true, however. One may be a value-based fund that has, in fact, posted quite good results relative to its true peers. A tendency to label funds as either bad-to-own or good-to-own based on a limited number of characteristics will lead to errors when other relevant characteristics are not considered. What should you do to overcome this tendency? Step back and look at the whole picture. Don't place too much emphasis on just a few shared qualities among various investments.

Myopic Risk Aversion: Many people have a tendency to be short-sighted when it comes to making decisions that involve potential losses—they place too much emphasis on the potential loss in the short term, without considering the long-term consequences. As an example of how this can affect investment decisions, consider your own retirement savings decisions. Each year's investment in stocks rather than a lower-risk alternative has the potential for a large loss. However, you have the opportunity to invest in stocks over a period of many years, and the long-term potential is very positive. Many investors in this situation, though, tend to hold less than the optimal amount in stocks because they place too much emphasis on the potential loss from a single year's investment in equities.

How can you overcome this short-sightedness? As a long-term investor, you should focus your asset allocation decisions on possible outcomes over your entire, long-time investment period, and not on single-period return possibilities.

2004 Copyright American Association of Individual Investors
www.aaii.com

 

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