Six Common Investing Mistakes
Tips to Recognize and Avoid 6 Common Investing Mistakes
We all like to think of ourselves as rational investors. But in reality, we are subject to psychological biases that, at their root, come from a deep-seated tendency to see the world from our own perspective. This can cloud our judgment and cause us to make emotion-driven decisions that might not be in our best interest, especially during the turmoil of the current pandemic.
You’re hardly alone though. Here are some very common investing mistakes that can arise from behavioral biases, followed by tips on how to avoid them. We’ve also included a list of those biases identified by behavioral finance experts to most often influence our investment decisions.
1. Selling winners, holding losers. A common mistake attributable to a number of different behavioral biases is the tendency to sell winners too soon and hold losers too long. Found to be about 1.7 times more likely to practice this blend of risk-averse (selling winners) and risk-prone (holding losers) behavior, these investors reduce performance by roughly 3.4 percent a year per a study of 97,000 past trades. To avoid this misstep, try setting investment parameters. Ask yourself: if you did not already own this, would you buy it at today’s price? Likewise, if an investment sustains a loss, set a threshold beyond which you will sell.
2. Investing high, selling low. One of the oldest adages in the investment world is to “buy low, sell high.” But in reality, many investors tend to do the opposite. A case in point is the frenzied market sell-off in first quarter 2020 as the global coronavirus threatened to push the world into recession. If you currently find yourself tempted to run with the herd and “sell the slump,” first take a look at historical performance: over six past major bear markets, an investor would have lost, on average, 38% between the midpoint and the bottom. Ten years later, that investor would have returned, on average 110% cumulatively from the midpoint of the drawdown. Then check in with your advisor to make sure your decision is based more on metrics, such as price/earnings and other valuation measures, rather than an overly emotional reaction to loss.
3. Trading too often. Do you find yourself constantly checking your portfolio balance or buying and selling on the market's ups and downs? Trying to time the market is generally a losing strategy, even for the market gurus. Evidence shows that the more frequently you look at your portfolio, the more likely you are to trade. And the more you trade, the more likely you are to reduce your overall return. A buy-and-hold strategy is almost always more appropriate, especially for long-term investors.
4. Under-diversifying. Lack of diversity in a portfolio can have serious consequences, exposing you to higher risk and potentially dramatic market swings. While there is no one rule for how much you should diversify, your portfolio mix should be a function of your goals and overall tolerance for risk. Advisors typically suggest diversifying by asset class as well as by individual investments. Pooled investments, such as mutual funds or exchange-traded funds, can help with the latter. Keep in mind however, that diversification is no guarantee of a profit or assurance against loss, but has historically proven to be a solid safeguard.
5. Focusing on the short term. Behavioral research indicates that investors tend to more heavily weight market risk stemming from short-term information and events, like quarterly earnings and monthly or weekly economic data. This tendency intensifies when we are exposed to risk in a particularly vivid way that underscores how far from the norm our lives have become – such as images of Pope Francis addressing only the pigeons in St. Peter’s Square. Despite an elevated fear gauge though, investors in the market for the marathon – not the sprint – tend to discipline their investing behavior by staying focused on long-term goals and not getting caught up in everyday noise or overreacting to the short-term volatility caused by rampant panic.
6. Going it alone. Several behavioral biases can cause us to make important investment decisions in a vacuum. Whether it is from a trusted friend or a professional advisor, getting a second opinion is almost always a wise move. And don't be afraid to rely on others who may be better qualified to make investing decisions for you. They might be able to short-circuit some behavioral predispositions and keep you focused on your goals.
Behavioral biases behind the scenes of many investment mistakes
Just recognizing the behaviors that are the root cause of the above mistakes can be half the battle. Here are the most common behavioral biases associated with investing.
All of these behaviors are hardwired into our brains. So, when buying or selling investments, consider why you are making a given decision. If, instead of drawing from objective facts and reasoning, you find yourself "going with your gut," try to identify which behavioral biases might be at work and how they might be clouding your judgment. Then, consider working with a professional who can help you to learn to become a more rational – and successful -- investor.
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