On December 31, 2018, the S&P 500 closed down -6.24%. During this time the VIX index, which measures the amount of fear in the market, spiked to over 30 points. For comparison’s sake, the VIX in 2017 was below 12. This amount of emotion in the markets can build irrationality into investor’s decisions, and can negatively impact investment performance results long-term. Morningstar.com reported that “Successful investing is hard, but it doesn’t require a genius…As much as anything else, successful investing requires something perhaps even more rare; the ability to identify and overcome one’s own psychological weaknesses.” Behavioral Finance experts, like Brett Steenbarger, have identified several traps investors unknowingly fall into when emotions run high. Below are the three frequent mistakes investors make during volatile markets.
Anchoring is a behavioral bias in which an investor relies too heavily on one data point to assess or estimate the value of a security or portfolio selection. A common form of anchoring for investors is using the price of the stock to determine its value. Individual investors will often look at how high or low the price of a specific stock is, and then decide to buy or hold off. Once the anchor is set in the mind, it becomes a bias for future investment decisions. The investor may view a high-priced stock as overpriced and a low-priced stock as a bargain. However, price alone is not a good indicator of future growth potential.
Anchoring occurs when people have a complex set of data to consider in the decision and want to narrow down the data points to something more manageable — for example, the purchase of a pre-owned vehicle. A buyer may focus in on two data points to drive their decision making, color, and mileage. The buyer may neglect the Carfax, how the automobile was used by the previous owner or the condition of the engine. Anchoring is a way of simplifying a decision. However, it can abridge the data too much, causing poor investment decision patterns over time. For investors, you want to overcome this tendency through self-assessment and awareness. You can also read this article by Charles Schwab to learn more.
Related: Overcoming Investment Regret
2. Sunk Cost Fallacy
Sunk costs, as the name implies, are irrecoverable costs. Performing a google search on this topic will lead you to articles with these phrases in the title, “…You Are Not So Smart,” “…Makes you Act Stupid,” “…Ruining Your Decisions,” and “…Hinders Your Life. When an investor purchases a stock or a fund that doesn’t perform well, it can lead to a sense that the money was already spent. This creates a nonchalant attitude about the security. When a person has made an expensive purchase, it can be tough to let the stock go at a loss, even when the data is indicating that there is no hope of its recovery anytime soon. This is how worthless stock can get into a portfolio. Rather than getting out at a loss, the investor holds until it becomes worthless. The sense that you will have wasted money if you sell at a loss causes you to hold the position longer than necessary and increases your actual loss. The Sunk Cost Fallacy can be created by a sense of responsibility or duty to see something through to the end. There are times that a poor decision or an investment that doesn’t pan out should be sold, and the sunk cost bias avoided. Sunk costs biases can impact a variety of areas of your life and can be a hindrance to sound decision making unless you honestly address this behavior and take steps to avoid its continuation.
Related: A Holistic Approach to Investing
3. Framing Effect
This psychological principle is used by the media to shape and influence how people view an event or situation. How information is framed can ultimately determine how people will respond to new knowledge. How many times in the last year has the media attempted to convince you that the stock market is crashing and recession is imminent? If enough journalists frame the new with this perspective, you are likely to be shaped toward their viewpoint, whether it is true or not. Counteracting the framing effect is as simple as considering contrarian options available and deciding what to do based on a more balanced viewpoint.
The bottom line is this: be aware of how your perceptions are impacting your decision as well as how other people are influencing your perspectives. Before making a decision take a few moments to determine if your decision is based on truth and reality or simply your perception of it. Learning how to manage these biases can improve your decision making and help you make better investment decisions. If you find that these biases continue to create harm in your wealth building efforts, then maybe it’s time to work with a professional money manager.
If you’re interested in learning how Lighthouse Financial can help you grow wealth responsibly and invest with confidence, then contact us today for a complimentary consultation.