The human brain uses a system of shortcuts to analyze and respond to potential threats. Thousands of years ago, this system helped us deal with dangers such as lions or poisonous berries. Today, however, these time-saving shortcuts can sometimes get in the way of making better longer-term decisions. When something makes our stomachs drop — like a 15% correction in the stock market — the survival instinct that’s buried deep in our brains kicks in and forces us to act to avoid the thing we’re most afraid of.
In this article we point out three very human ways of thinking that can sabotage your portfolio. In each instance, ask yourself whether you’ve ever had the thought. If so, we’ll explain what might be at work and suggest ways to retrain your thinking.
1. 'I’ll sell this stock when I can break even.’
Let’s say you have a goal of buying a home in 10 years and to help you reach that goal you’ve invested $10,000 in a stock. Let’s assume the stock did well for 18 months but since dropped to $7,500. What would you do? Sell? Or continue to hold under the assumption that what goes down must come up?
Chances are you picked the right answer: Sell to avoid further losses. Hoping that the stock will recover enough to break even is usually based on “anchoring bias.” Anchoring simply means we are most influenced by our first impression. The potential growth that you initially saw in the stock is very difficult to reconcile with the idea that it may be losing money.
A second bias is the “sunk-cost effect.” This bias keeps us from forgetting about money we’ve already spent. We feel like we have to wait until the investment pays off instead of recognizing the opportunity lost by sticking with a loser.
To correct for anchoring bias, you need to remind yourself that a stock’s purchase price is not the same as its value. And as for avoiding the sunk-cost effect, you need to be willing to let go of an investment that isn’t performing well.
2. ‘I'll focus on my retirement once I have more saved.’
A common excuse for not saving for retirement is, “I don’t have the money.” Most of us have great difficulty planning far off into the future. This feeling of “it’ll be OK, I’ll deal with it later” can really sabotage your goals.
Our brains prefer the status quo, a bias that stems from our need for normalcy. We like what we know, even if what we know isn’t all that great. Another bias is decision fatigue. We are faced with making so many decisions over the course of a day or week that our decision-making energy runs down.
Will your bank savings be sufficient enough to carry you to and through retirement, or do you need a more comprehensive plan? You need to consider all investment options on the table. Schedule time to confirm that your investments are performing as expected.
3. ‘I’ve been doing fine so far. Why do I need an advisor?’
How would you rate your driving abilities? Top third, middle third or bottom third of all drivers? A 2018 Psychology Today research study on overconfidence showed that 90% of people put themselves in the top third of drivers and very few rate themselves below average — even though in reality one-third would evenly fall into each category.
If you’ve been managing your own investments, chances are you’ve been doing an average job, making some good and bad trades. But if you’re overconfident, you may think you’re doing a better job at trading than you really are.
Without even thinking about it, we are very good at taking our experience driving (or investing) and constructing a compelling story to convince ourselves that we’re above average. Overconfidence bias has a close analogue: self-attribution. Think of a time you’ve played cards or fantasy football. When we win, it’s because we’re skilled competitors, but when we lose, it’s just bad luck.
To counterbalance overconfidence and self-attribution, it pays to be humble. We don’t know what we don’t know. Unlike the townspeople of Lake Wobegon, we can’t all be above average.
Next Steps
If you’re your worst enemy when it comes to managing your money, here are three steps that can help put yourself on firmer financial ground.
- Set specific goals. It’s not enough to say that you don’t want to run out of money. Where you want to live, how to spend your time, whether you need to provide for other family members, and what your spouse or partner wants to achieve in life are all important things to think about and set goals around.
- Make a long-term plan. A written plan will let you know what income your assets will need to generate, allowing you to properly calibrate your risk. An experienced financial adviser can help with this.
- Implement and keep refining the plan. Just landed a new job? Getting married? Starting a business? Selling a business? Whenever a major life change occurs, take time to revisit your financial plan and make sure it’s still relevant an accurately reflects your wishes.
The most important thing is to make sure you’re comfortable with the risk you’re taking, and that your decisions are based on your long-term goals and not on today’s market fluctuations.
If you’re interested in learning more about this topic, please call Wealth Enhancement Group at 1-888-819-5520 and request a copy of our e-book, Are You Sabotaging Your Investment Success?
This article was originally published in the Pioneer Press.
