If investing and saving for retirement were based solely on objective mathematics, a healthy nest egg could be a forgone conclusion for many of us. Realistically, however, investors are human beings, with wants, feelings, conflicting priorities, and a wide range of emotions. In fact, a subfield of behavioral economics called behavioral finance studies how psychological influences and biases affect the financial behaviors of investors.
While there are many facets to behavior finance and its complexity behind the science, some of the concepts can be simplified to help the average investor identify and change damaging thoughts and behaviors. These include the emotional biases of overconfidence and herd behavior.
Overconfidence is an emotional bias that is ubiquitous in an up market. When individuals see impressive gains in their portfolios, it can distort their decision making. Winning can create emotional highs and disconnect us from rational behavior.
In addition to being overconfident in the market, an investor can also be overconfident in his or her abilities. After all, we all think we are great drivers, yet every year tens of thousands of traffic fatalities occur. Like driving, investing has inherent risk. We need to be aware of the risks and take steps to help mitigate those risks. Just like seatbelts cut down on our risk of dying in a car accident, exercising prudence and caution in a financial plan can help protect us from devasting losses.
Therefore, when looking at your investments, exercise some introspection about your level of confidence.
- Are you giddy because your portfolio is so high?
- Have you taken steps to also consider what your losses might be, and can you comfortably accept those losses?
- Are you ignoring the voices of financial analysts who are encouraging prudence?
Following the herd
Likewise, another emotional bias is herd behavior. In essence, we may ignore our own inner dialogue of caution or the evidence of professionals and instead “follow the crowd” and its strategies. The most detrimental way we see this work in practice is when an up streak is featured throughout the news. This triggers “herd” investors to buy stocks (at a high price). When the news is filled with market declines, and they see their accounts tumbling, herd investors sell (at a low price). People also do the same in their 401(k)s, transferring money between sub accounts at the worst possible times. The buzz of “now” gets into their heads, and the old adage of “buy low and sell high” goes out the window.