Researcher Dalbar, Inc. examined the effects of investors’ decisions to buy and sell their mutual funds. Here are their findings:
Investors are prone to certain emotional – and often irrational – biases that affect their ability to make sound decisions about money. There is even an increasingly popular academic field, called Behavioral Finance, that explores the motivations luring deep in an investor’s mind. Some of the principles include:
- The recognition that the major mistake people make is that they are not very good at dealing with a lot of uncertainty. Rather than a rational assessment of data and probabilities they like stories, and they make decisions based more on mental images rather than a sober assessment of their portfolio and how to incorporate any new information.
- People tend to chase returns and are buying whatever the new hot product is which leads to people first picking the investment, rather than deciding how the portfolio should be allocated.
- Overconfidence is a common flaw. Men tend to be more overconfident than women, and men tend to trade more actively than women, which usually ends up hurting their overall returns. People tend to think they know more than they actually do, which leads to a false sense of security.
- Investors also tend to feel more secure in their choices when following the herd, or doing what everyone else is doing. This is the idea that investors feel more comfortable in making financial decisions that are validated by the action of others, and tend to feel scared when they see others taking an opposite approach.
- People tend to focus too much on what has happened recently and overreact. This is true in terms of positive events as well as unfavorable and unsettling negative events. Investors tend to overreact in bull markets by continuing to buy winning asset classes, such as dot-com stocks, and also explains why the bottoms of bear markets tend to have such climactic endings.
- Investors tend to project recent patterns into the future. There is this tendency to buy the stocks or mutual funds that did well last year, buying last year’s story.
- Some investors become “anchored” to certain reference points that influence there decisions. This includes assuming economic factors are unchanged, or that certain prices always remain the same.
- Investors are reluctant to sell at a loss, and conversely, are inclined to sell (sometimes too early) because they want the positive reinforcement that comes from securing a gain. They tend to hold on to their losers and sell their winners.
- Some tend to treat money differently based on where it came from or where they hold it. An example is that many treat tax-return money as lottery winnings or found money.
Once these patterns are recognized action to avoid these emotional pitfalls are:
- Create a formal financial plan and stick to it. The plan should be based on your individual goals and time parameters.
- Try not to get distracted by the constant stream of information, changing opinions, and brokerage statements values.
- Keep a long-term perspective, remain adequately diversified, and rebalance your portfolio. Trim back on areas that have become inflated, and buy things that are temporarily depressed or don’t necessarily appear to be in vogue at the time.
The bottom line is: Taking the emotion out of the decision increases the chances that it will result in a rational move and raises the possibility of achieving a successful outcome.
Please note, the options voiced are for general information only. They are not intended to provide specific advice or recommendations for any individual and do not constitute an endorsement by LPL Financial. To determine which investments may be appropriate for you, consult with your financial professional. Please remember that investment decisions should be based on an individual’s goals, time horizon, and tolerance for risk. Indexes are unmanaged measures of market conditions It is not possible to invest directly into an index. Past performance is not a guarantee of future results.