Part 8 of the series: Rethink the Way You Invest.
Despite all our efforts to deal logically with our money, we all fail to some degree or another. Emotions can destroy your wealth.
Behavioral finance examines the influence of social beliefs, psychology, and emotion on economic decision making. Research suggests that humans are not naturally wired for making good investment decisions, due to cognitive errors and behavioral biases.
My son (and associate) Matt has a degree in psychology, so I consulted with him and leading industry research on this topic. We then had a family meeting and came up with our own names for eight different named emotions and biases. I have included the formal terms in brackets:
- The Titanic Effect (Overconfidence). People get cocky, overestimate their ability to anticipate future investment results and often neither see nor prepare for the icebergs ahead.
- I’m smart but hey, stuff happens (Self-serving bias). Investors may take credit for their successful investment decisions, while blaming bad outcomes on outside influences.
- Should’a, could’a, would’a syndrome (Hindsight). When viewing past outcomes, investors may apply selective recall and conclude that future movements were obvious at that time. They usually forget market opinions that swayed in the opposite direction.
- Life in the rear-view mirror (Extrapolation). Investors may expect recent market results to continue in the future, and may place too much weight on certain factors or recent events. There is a reason why many investment disclaimers say, “past performance is no indicator of future results,” because it is true!
- The Comfort Zone (Familiarity). People may limit investing to areas in which they are familiar, resulting in a false sense of control. Despite this perceived “inside knowledge”, no one can predict future returns.
- Mental accounting (Thinking inside the box). People partition their wealth in categories, resulting in inconsistent and fragmented financial decisions. A better approach is to see all components of wealth within a comprehensive framework.
- Don’t go breaking my heart (Regret avoidance). Investors who have experienced painful financial events tend to avoid those investments in the future. For example, those who sold their portfolios into cash in early 2009 permanently destroyed their wealth, while those who stuck to their long term plans preserved and grew wealth.
- Cherry picking (Confirmation). Investors seek out or interpret information that confirms what they want to believe about an investment, markets, or their own skill.
It’s time we end the madness and stop playing head games with our money. Spend the time to formulate a plan, learn how to logically access long term returns, how to mitigate risk and how to avoid being sabotaged by your emotions and biases.