Some of the most hackneyed suggestions you’ll hear from financial advisers is, “Don’t invest with emotion.” We’re going to gently push back on that notion a little.
The reasons why you invest are deeply emotional because the stakes are high. This isn’t about scorekeeping, it’s about ensuring that your loved ones—yourself included—are provided for when you aren’t generating income anymore. And it’s about taking control of deciding exactly when that day comes, rather than having it arrive unannounced. So you have our permission to be passionate about this domain of your life.
The trick, though, is to have a plan and to make sure your investments serve your passions rather than the other way around. So let’s take a look at some of the investing biases that often get baked into our decisions. Just being aware of common behavioral finance biases will allow you to insulate yourself against making mistakes based on them.
Number One on the bias list has to be what’s called “loss aversion”. Here’s an example: Let’s say you bought a stock at $50, and it goes down to $40. The natural inclination is to wait until it goes back up. But there are two problems with that thinking. First, what if it never does? Then you’re stuck with a loss. Second, what if it does … but it takes a long time? What if by the time it crosses that magical $50 barrier again and becomes a win, you could’ve sold your slightly-reduced holding and moved the money into a stock that was making gains fast enough to make up the difference, and then some?
That’s a major impediment to sound decision making, year in and year out. But over the course of this past year, what had been a relatively benign source of misinterpretation has become one of the most incredibly oversized investing biases: “the bandwagon effect” (Number Two if you are counting along with us).
That’s what it’s called traditionally, but as Bitcoin’s price rose from the hundreds to the thousands to the tens of thousands, the bandwagon effect earned a new name: FOMO. That stands for the Fear Of Missing Out. Certainly, blockchain technology is here to stay and cryptocurrencies aren’t going away anytime soon, but the rise in Bitcoin probably has as much to do with the herd instinct and FOMO buying as anything else. Remember that momentum players eventually run out of momentum, but contrarians are almost always proven right … eventually.
Number Three and perhaps the most pernicious risk to good investing, though, is what’s called “present” bias. This behavioral finance bias is the tendency we all have to sharply discount the importance of the future when making decisions today. You could make the analogy to overeaters. Alcoholics know they need to stop drinking. Gamblers know they need to stop gambling. These vices are rooted in unnecessary activities. But we all have to eat, so it’s easy for an overeater to discount the future health effects of his gluttony when he’s really hungry right now. An overeater needs to find a healthy way of approaching food.
Similarly, the entire financial world is predicated on discounted cash flows: the notion that a dollar today is worth more than the promise of a dollar tomorrow.
That doesn’t mean tomorrow isn’t important, but our tendency to fall victim to “Present bias” leads to some of the most devastating misallocations of resources we can make. Consider this: according to one study, more than a quarter of younger workers haven’t saved any money at all for retirement. And more than one-third of all workers of all ages have set aside less than $1,000 toward retirement. Now to some degree, this is unavoidable. A lot of people simply aren’t getting paid what they’re worth. But readers of this column tend to be compensated well enough to be able to take ownership of their financial future. One good way to approach this is to make sure that you’re investing every dollar for which your company provides matching funds, and every fractional share of stock the company is offering to employees at a discount.
Ultimately, though, the best way to avoid the catastrophic results these investing biases can lead to—along with the other ones we didn’t have the time or space to discuss here—is to have a planning discussion with a financial adviser who can provide you with the independent, clear-eyed view that can save you from a host of tricks of the mind.
Fear and greed are some primal emotions. So is love for your family. But in its own way, sober reflection is also an emotion. Let it work for you.