Avoiding these 4 psychological investing ‘traps’ can improve your portfolio’s performance
What’s the best way to avoid making costly investing mistakes? By recognizing the impulses wired into our brains that serve us ill. Dodging bad psychology-driven practices, after all, is at least as important as finding a winning strategy.
Here’s the problem with us humans as investors: Knee-jerk responses too often can overwhelm our judgment, especially in an anxiety-filled time like a stock market rout. The danger reflex is particularly strong. When prehistoric Homo sapiens heard a large growl in the forest, they raced for their caves. That same urge appears when the market is in free fall. But it should be shunned.
There’s a whole body of academic study, called behavioral finance, that seeks to instruct investors on how to protect themselves from themselves. Investment firm Alger just released a new report that spotlights self-defeating investor biases, such as equating a modern-day market fall with a saber-tooth tiger.
To Brad Neuman, Alger’s director of market strategy, the meme stock craze is a cautionary example of investors deciding with their gut, and he predicts their results eventually will be unpleasant. “They want to make money quickly, with high volume and small stocks that are profitless,” he says.
Rick Kahler, head of Kahler Financial Group in Rapid City, S.D., recalls how in the 2008 financial crisis and the March 2020 plunge, he had to talk clients out of selling off their hard-hit portfolios, which they thought might go to zero. Research shows bear markets turn around, he told them.
Let’s face it: Not everyone is an investing sophisticate who performs coolly under fire. The Alger study shows that institutional investors—the professionals who tend to deploy money in a systematic, research-heavy way—do better than ordinary folks, known as retail investors. Over the past year, stocks with high institutional ownership increased their performance by 3.5%, while the retail-favored stocks slid 6.8%. Presumably that’s partly because these ordinary investors made ill-considered moves, such as the ones Kahler counseled against.
Here are some toxic behavioral prejudices, as outlined by Alger and others, to steer clear of.
Herding Bias That is, going along with the crowd. Witness the meme stock gang, who have an online community that looks for the next hot buy, however dubious. On a psychological level, this is understandable: We are social animals, and have been ever since our primeval ancestors banded together to gather food and avert predators.
The desire to fit in with the group can bring disaster, though, as the sorry outcomes of investment fads throughout history attest. In the 1600s, Dutch investors were crazy for tulips, and the price of a single flower could cost as much as a home in Amsterdam. In the 1990s, dotcom companies were the in thing, even though many of them had no hope of turning a profit. The outcomes for tulip and dotcom investors were gruesome.
Availability Bias Here, investors grab on to the most readily available information, and don’t bother to look any further. One example: Americans’ home-country preference. They invest in what is familiar, U.S. stocks. So they own just $3 trillion in international equities and a daunting $10 trillion in domestic ones (via mutual funds and exchange-traded funds), an Alger study found. Trouble is, the U.S. gross domestic product is 27% of the world economy, and many developing nations such as Brazil and India have much higher projected growth rates.
Confirmation Bias In a similar vein, some people find it easier to glom on to data that supports their hard-and-fast viewpoint and dismiss whatever doesn’t. In the classic tune, “The Boxer,” by Simon and Garfunkel, is an apropos lyric: “A man hears what he wants to hear, and disregards the rest.”
Lehman Brothers Holdings once was one of the most innovative and profitable firms on Wall Street. It discovered a further path to riches in the subprime mortgage market, which fueled the housing boom in the decade’s first century and made the investment bank still more money. Even as evidence gathered of mounting subprime loan defaults, die-hard Lehman believers kept its stock aloft: The shares hit a record $86 in 2007. A year later, the company collapsed. The stock was worthless.
Recency Bias What just occurred is most important in investment planning, the thinking goes. Those harboring this mindset neglect to examine trading histories and economic trends, which require some bother. Thus, after the market took off after its March 2009 low, many investors withdrew from stock funds. The 2008 debacle was too vivid in their minds.
They missed out on a huge rally that erased their losses and kept on rising for years.
Lately, the enormous run on large tech stocks has been fueled by the overoptimistic version of recency bias, known as the momentum play. As the Big Five tech companies (Google parent Alphabet, Amazon, Apple, Facebook, and Microsoft) spiraled ever higher, a lot of investors became convinced that their upward trajectory had no limit. But Facebook’s entanglement in myriad controversies, complete with bipartisan congressional condemnation, is a reminder that even the mightiest companies can fall to earth. America Online and Digital Equipment Corp. were among the hot tech names of the 1990s. They’re just memories now.
In Nassim Nicholas Taleb’s book The Black Swan, he spins a parable about a turkey who figures it has a sweet deal because a friendly farmer feeds the bird every day. Come November, this familiar pattern proves…unreliable. Investors, too, would do well to remember: Past performance is no guarantee of future results.
This article is part of Fortune’s quarterly investment guide for Q4 2021.