As much as investors try, it can be challenging to remain rational in the investment decision-making process. Emotions and psychological influences can often cause havoc even for the most rational and level-headed investors. Numerous studies by research firms and academia seek to quantify how much irrational behavior affects investor investment returns. The chart below provides one such study that illustrates several asset classes and diversified portfolio returns, along with what the typical investor has experienced over the last 20 years.
To help in challenging times, it’s best to understand the types of errors investors can make and understand your long-term investment strategy. Much of investment and economic theory is based on the premise that individuals behave in a rational manner. But research has found that investors don’t always make rational decisions when facing short-term conditions. Here are a few of the more common missteps investors make:
Herd Bias
As humans, we tend to “go with the crowd.” The inherent benefits for going with the masses are fulfilling the desire for acceptance, providing a high level of comfort, and confirmation of our investment decisions. Socially, conforming to the norm is simple and in many ways expected. However, when it comes to investing, following the “herd” is what pushes markets to extremes, both during run-ups and pullbacks. It is challenging to be a lonely contrarian or move against the crowd, but this is where significant profits are made by investors over the long-term.
Short-term Focus
Our conversations with investors tend to focus on long-term goals, as they should. Investment strategies are built for longevity. In spite of this, investors often exhibit very short-term behavior, like the desire to make frequent trades or overreacting to short-term market volatility. Given our world of instant access to information, the accelerating media cycle and persuasive headlines, the temptation exists for investors to get caught up in the frenzy. Periodic review of an investment portfolio is necessary, but so is resisting the temptation to behave as if their time horizon were far shorter than it truly is.
Anchoring Effect
Also known as a “relativity trap,” the anchoring effect is the tendency for investors to compare their current situation within the scope of their own limited experience. When we buy a mutual fund and it goes up, we remember that well and become anchored to the fund or emotionally attached. Conversely, if we buy a mutual fund and it goes down, we tend to dislike that fund even if the fund was simply bought and sold at an inopportune time. The fund might be one of the best long-term risk-adjusted performers, but the experience was negative, so we might end up avoiding it. This behavior leads to performance-chasing over time. All of these investor pitfalls, and others, lead to long-term lower investment returns.
Does all this seem difficult and complicated? Professional investment managers can help in the form of developing deliberate, specific investment strategies. Learn more about how we can help you reach your investing goals, and start the conversation now!
