Overcoming 3 bad investing behaviors

Do you avoid the stock market? Shun diversification? Trade inefficiently? We all have our Achilles heels – here are some of the biases that may be influencing your behavior, and what you can do to counteract them.

Many finance experts assume that investors act rationally – seeking to maximize profits while minimizing risks. And most investors would probably agree that their decisions are driven by those same motives. But investors routinely make a number of irrational missteps that can be explained by a growing body of behavioral finance research, which studies how people make money-related decisions. Here’s a look at three of these common investing bad behaviors.

1. Stock market avoidance: many people shy away from investments that are perceived as being risky, like the stock market, despite the potentially high cost of staying out of such investments. Over time, inflation could degrade the value of cash, so savings that aren’t earning some kind of interest or return might be a losing proposition.

So why the reluctance to invest more? Studies in the field of behavioral finance have found that investors are roughly twice as sensitive to losses as they are to gains. And people tend to evaluate gains and losses over a relatively short time horizon that may not be in sync with the longer horizon over which investment goals are expected to be achieved. This extreme fear of losses in the near term, combined with people’s tendency to look at each investment in isolation, means that investors can be unduly protective of their current cash and miss the big picture of what investment can do over decades. To try to counter this bias, do some quick and dirty math – what will 1% yearly inflation do to your savings? And what could a relatively modest 3% return do over that same amount of time?

As you do, keep in mind that the costs of investment also accrue over long time periods, keep in mind that the costs associated with investing will also take a bite, so consider the costs of investing as well as the possible risks and returns.

2. Insufficient diversification: another common investor mistake is to have an under-diversified portfolio. One study concluded that a diversified portfolio should include at least 10 to 15 stocks. And generally speaking, the more diversified portfolios performed better: as this study from Fidelity shows, when hypothetical portfolios were run through a simulation of the 2008-2009 bear market, the more diversified portfolios displayed greater resilience. While the study highlights diversification’s potential benefits, it’s important to note that diversification may not protect against market risk or loss of principal.

Behavioral finance concepts behind this mistake include investors’ tendency to use certain rules of thumb (for example, dividing assets evenly into funds) for allocation decisions, and opting for the most familiar stock names over ones which might be a better portfolio fit.

3. Inefficient trading: many investors tend to move in and out of positions in an inefficient way, reducing their potential profits. This may be because individual investors are often overly confident in their own abilities to beat the market, and thus trade excessively and hurt their portfolio performance.

Many investors also often make the cognitive mistake of extrapolating from past returns, buying assets whose prices have gone up in the expectation that prices will continue to increase. At the same time, people tend to be more likely to get rid of stocks that have done well in the past and to keep the losers so as to avoid the mental pain associated with realizing losses. In behavioral finance, this latter concept is known as the disposition effect and it’s particularly striking considering that based on tax considerations, people would be expected to sell losers to exploit capital losses and defer taxable gains.

The good news is that you can consider certain steps to possibly help mitigate the impact of these common mistakes. These include:

  • To feel more comfortable about investing in risky assets, consider focusing on the overall portfolio rather than focusing on each asset in isolation. In addition, consider viewing investments from a longer time horizon, which might help smooth out fluctuations in stock market performance.
  • Consider increasing portfolio diversification by investing in diversified ETFs.
  • Consider rebalancing a portfolio periodically with a rules-based or systematic investment approach to help lessen investor biases.