Should you invest the way Bob does?
Let's explore the psychology of why many investors aren't successful
Here we are headed into fall with U.S. stocks at all-time highs and fears of the great recession still haunting the minds of investors. The never-ending cable media cycle continues to make entertainment out of investing while investors foolishly make investment decisions based on emotion and advice from amateur sources.
There are many practical articles and sources available to investors that provide sound advice about investing. So why is it so many people stray from this practical advice and continue to make mistakes? Could it be that our deepest behaviors that allowed our ancestors to survive works against an investor’s ability to make sound investment decisions? Let's explore the psychology of why investors are not successful.
You know who you are! The person who read the first paragraph of this article and immediately started thinking that you don’t make poor investment decisions. Human beings tend to be overconfident. Without overconfidence, many inventions, companies and ground-breaking research would never happen. Overconfidence with investing can create risk and hinder investment returns. Many of my clients are some of the smartest people in Colorado, but their success does not translate into investing. Smart investors know their limitations and receive help from competent sources.
Keeping Up with the Joneses
You are friends with Bob at work. Bob is about your same age and you respect Bob’s intelligence and work ethic. You are eating lunch with Bob, and he tells you how he earned an 8 percent rate of return in his 401(k) over the last six months. You immediately internalize the 3 percent you earned and rush back to your desk to pour all of your retirement assets into the investments Bob is using. After all, you have to keep up with Bob.
Unfortunately, Bob did not tell you how he lost 15 percent the six months prior to his gain with the same investment strategy. On paper, this scenario looks ridiculous. Why would anyone jeopardize thousands of dollars based on a conversation with a coworker with no investment expertise? Yet, this scenario plays out daily with friends, neighbors, and coworkers across America. Investors need to focus on the probability of success of achieving their goals and not keeping up with the returns of other investors.
Attraction to Rising Prices
Normal human behavior would dictate an inverse relationship to rising prices. For example, if the cost of gasoline or milk rises, many consumers buy less or find an alternative. This behavior when applied to investing is the opposite. Investors flock to asset classes, stocks or funds that have gone up significantly ― incorrectly assuming the increase will continue. Buying high and selling low is not a prudent investment strategy.
Fear of Making Mistakes
This is typical of the investor who still is haunted by the great recession or has that constant fear of events or circumstances that may negatively affect the market. Have you ever left a sum of money in your bank account because you didn’t know what to do with it, or you were afraid of the market? Leaving a large sum of money in a bank account earning next to nothing is an opportunity cost lost. Investing is like having a baby, there is never a perfect time to do it.
In the wild and with human nature, there is comfort being part of the group. We are more comfortable in situations when other people are doing the same thing as we are. I have no doubt this herd mentality has saved many people and animals throughout history. Investing is different. With investing, when the herd moves one direction, it is sometimes wise to move in the other direction.
The Stakes are High
With investing, the stakes are high. Real money is made and lost and retirements, college education, and dreams are achieved or squandered based on extremely important decisions. Yet, many investors have made decisions or continue to make decisions regardless of what common sense dictates.
With the stakes so high, why do so many investors follow investment advice based on one article they read, talking heads on cable television, or simply a coworker? Is it because some of the ingrained human behaviors that have kept humans alive and achieve greatness are a detriment when it comes to investing? Investing takes discipline, planning, and knowledge over a sustained period of time. Understanding why investment decisions are made may prevent mistakes in the future.