Psychology has spawned many sub-specialties, so it should come as no surprise that there is one for investing: behavioral finance. This field originated back in the 1970s for the express purpose of studying behavioral trends as they relate to financial markets.
Believe it or not, behavioral finance has developed a number of useful insights about investor behavior. Here are three particularly insidious investor biases:
Avoidance of investment losses – Oh, how we investors so hate to lose money! Numerous studies indicate that investors feel the pain of investment losses at least twice as strongly as the pleasure associated with gains of similar magnitude. That pain complicates the way we deal with those losses…and…our response has EVERYTHING to do with EGO! Human nature makes it difficult to admit that we erred, and that part of our nature has contributed more to investment losses than most, if not all, other factors. We all know how this works: I’ll sell as soon as I get back to even!
Overconfidence – Those psychologists and their studies…but multiple studies show that more than seventy-five percent of drivers believe that they fall into the “excellent” category. Ten minutes on Madison’s Beltline will dispel that notion! The same applies to students: more than eighty percent believe that they will end up in the top half of their class. So much for new math! As an investor, how do you feel about your ability to outperform the market? Most think they can!
Information Overload – There is no shortage of investment and economic information, and that confuses and clouds investors’ judgment. Still more studies…including one from Harvard…strongly indicate that investors who closely follow news updates actually fare worse than their less engaged investor counterparts. Why? Think poor performance due to excessive trading and market timing!!
I wonder if studies have proven that working with a competent and experienced advisor can help avoid these harmful biases! What do you think?