When viewed at the surface level, investing seems to be all about facts and figures: principles, interest rates, etc. Yet, for every single investment made there’s a human element that shouldn’t be overlooked because human beings bring a wide range of complexities to investing that aren’t directly related to the numbers.
In fact, an entire area of psychology known as behavioral finance is dedicated to understanding how the decisions made by investors and financial analysts affect market outcomes. We’re all susceptible to biases and influences that impact self-control, risk tolerance, and rational behavior. Below, we’ll delve into two of the biggest culprits – herd behavior and overconfidence – and how they could be sabotaging your plans. Once you are aware of them, you can combat the negative behaviors and move beyond them for greater financial success.
#1 Herd Behavior
Have you ever been driving, and it seems like everyone around you is traveling above the speed limit? If you’ve picked up the pace to “go with the flow of traffic,” you’ve exhibited herd behavior. In finance, herd behavior looks like buying into a stock that is being touted as a money-maker because it appears to be on a winning streak, despite financial advisors cautioning against it and the stock coming at a high price. But, as we know, the market will inevitably shift – and none of us can time it. When it declines, herd investors try to offload these investments, even if it means selling for less than they originally paid.
Overall, it’s a reactive approach that will always leave you a step behind. If you are a herd investor, you will always be chasing the next big stock. Instead, focus on your own financial goals and plans. What are the long-term projections for your investments and is your portfolio diversified enough to meet your personal risk tolerance but still allow for growth? These are the moves that will truly help you build wealth from your investments over time.
You may be exhibiting herd behavior if:
- You frequently move money around in your accounts and investments during a down market (bear market)
- Frequently purchase or add more money to your accounts and investments in an up market (bull market)
- React to news about the market – whether up or down – by adjusting investments
- Ignore or forget your overall financial plan by focusing on the “here and now”
If you see yourself handling your investment portfolio in this way, remind yourself to pause before making a move that is emotional rather than rational.
When the market is up, so are the emotions of investors. Watching your portfolio perform well and bring in gains can inflate your sense of confidence in both the market and your own financial acumen. It’s a great feeling while it lasts, but it may also propel you to take on riskier investments than you normally would in order to keep winning.
Unfortunately, that winning streak is uncertain and will surely end at some point. A downturn in the market could spell major losses if you haven’t been prudent about diversifying your portfolio, which can shield you from asset-specific risk. If you’ve shifted all your money into high-risk, high-return investments in one industry and that industry takes a hit, your money definitely will take a hit, too.
So, don’t let an up market beguile you and compromise your decision-making. Instead, consider your portfolio as a whole, and be sure you have the proper balance of funds to mitigate risks should the superstar in your portfolio suddenly stop performing. That’s not to say you should avoid every high-risk, high-return investment opportunity you encounter. Just be sure you are comfortable with any losses that such an investment could potentially bring with it.
Are you worried you’re making decisions based on overconfidence? Here are a few clues:
- You get extremely excited when your portfolio is performing well
- You ignore the potential consequences of losses in your portfolio while in a bull market
- You disregard financial advisors and other experts when they encourage caution or diversification
If this sounds like you, take measures to ensure your confidence doesn’t get the best of you.
With pensions falling by the wayside over the past few decades and the uncertain future of Social Security for the next generation of retirees, you will likely need to have some money invested if you plan to reach your retirement goals. Exercising shrewdness and prudence in your investment approach will serve you well. Understanding how you think, feel, and act as an investor is also important. What emotions and biases drive your feelings toward your money? Can you keep yourself focused on the long-term goals of your plan?
If you find yourself exhibiting some of the behaviors mentioned above, you’re not alone. We are all human and prone to emotional reactions. Acknowledge them when you see them at play, think about why you react that way, and work to address that unconscious behavior as best you can. Don’t let a momentary reaction to something happening now sabotage your plans for retirement.
If you’re serious about getting your plan together for retirement, Resolute Wealth can provide not only the financial expertise you need but also a customized approach to achieve your unique goals. Start the conversation by reaching out to us today.