In most areas of life you can count on knowledge and experience to help you make smart decisions. Investing, you may have noticed, doesn’t always work that way.
“Human beings have certain innate tendencies that don’t always lead to the best investment choices,” says Mark Riepe, senior vice president at the Schwab Center for Financial Research.
In fact, even those who spend their professional lives poring over financial statements and crunching numbers often fall prey to the same unhelpful reflexes that frequently trip up the lay investor. Fortunately, you can put controls in place to help you quash these self-defeating impulses. Here are three minefields you’re likely to face and a plan to sidestep each of them.
The problem: You hold losers for too long. Why you do it: If you’ve got some laggards in your portfolio, hanging on and waiting for them to bounce back might seem like a sensible strategy. But behavioral finance experts call this shortsighted strategy “loss aversion,” or a resistance to realizing losses, says Mark. “No one likes to admit they’re wrong, and the ultimate admission of being wrong in investing is taking a loss,” he says.
Indeed, research by Berkeley finance professor Terrance Odean found that investors were 50% less likely to sell a losing stock versus a winner. Worse, the losing stocks they held onto still tended to underperform. “Investors who sell winners and hold losers because they expect the losers to outperform the winners in the future, are, on average, mistaken,” Odean wrote.
What to do: When it comes to individual securities, create a list of sell triggers when you buy the stock. Periodically review those triggers, and if any are tripped, sell. Also exercise what psychologist call “reframing,” says Mark—that is, viewing the information from a different angle.
In this case, you can think about selling at a loss as a boon to your tax bill: you can write off up to $3,000 of losses against ordinary income this year and roll any excess into future years. Still find it hard to stick to that discipline? You may want to work with a financial professional who can stick to the game plan in your stead.
The problem: You act on your hunches. Why you do it: Human beings naturally attempt to find patterns in all things. In one study, humans, pigeons and rats were shown a random sequence of flashing red and green colored lights. They were then rewarded for picking the color of the next flash. It wasn’t hard: 80% of the lights were green and 20% were red.
While the pigeons and rodents quickly learned that picking green all the time would maximize their reward, the humans persisted in attempting to find a pattern in the flashes, leading them to score worse than the animals!
Sadly, we succumb to a similar search in the performance of stocks and bonds, says Mark. “We think we see patterns where none exist,” he explains.
Compounding the problem: a phenomenon known as “confirmation bias,” which leads us to welcome information that confirms what we’re already thinking, and discard what isn’t consistent with our views.
What to do: Before you buy any investment, note what changes in the business or market would make it less attractive. For example, how would that Canadian energy company fare if regulatory changes opened up new U.S. pipelines in the Gulf of Mexico?
“Writing down the pro and con list will help you make a more thoughtful, balanced decision,” says Mark. If you find it difficult to take an unbiased approach to a variety of data, consider exposing yourself to other points of view. Pay particular attention to firms and analysts that have opinions that differ from yours. In addition, take a look at Schwab Equity Ratings, which are based upon a disciplined, systematic approach to analyzing potential investments.
The problem: Always looking for the “next big thing.” Why you do it: There is a rush of excitement that comes when you think about the potential gains if the stock you’re investing in turns out to be the next Google. It’s fueled by dopamine, a powerful neurotransmitter, giving you the equivalent of a natural high—and short-circuiting the sensible part of your brain that could determine whether a given stock is likely to be a stinker.
While a dopamine rush might have been a useful benefit hundreds of thousands of years ago when we were a developing species, constantly chasing rewards as an investor isn’t likely to do your portfolio any favors.
What to do: Enjoy your thrill, but make sure you take steps to limit the downside. Take a cue from pro traders, who generally have limits on how much capital they can put toward a single investment. Cordon off a piece of your portfolio—say, 5%—and stick to only that amount for long-shot ventures. And put those rules into place now, before you fall in love with an investment.
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