Editors' pick: Originally published March 7.
Here's today's understatement of the year: emotion plays a major role in investing.
Whether it's the gold rush leading to 2008's crash, momentum trends that cause a stock to orbit its true value or the irrational exuberance of the 1990s, the stock market is filled with people who act like, well… human beings. Perhaps unsurprisingly, this has its strongest expression when it comes to individual investors.
That's not always bad. Emotions come into any big decision, and it's important to feel good about your portfolio. Emotions dictate risk tolerance, after all. The same goes for picking companies with a strong sense of mission. Those are the decisions that help you sleep at night.
The problems start when emotions become biases. That's when you, as an investor, can make bad choices that don't leave you personally or financially any better off. What do those biases look like? Here are the top ten to keep an eye out for the next time you open up the portfolio…
Bias: Focusing on an actual or perceived expertise on a narrow slice of the market
Overconfidence isn't necessarily what it sounds like. Yes, sometimes this bias is cause by an investor who knows less than he thinks. That guy who caught 15 minutes of "Mad Money" and then gives lectures at a dinner party is a classic example.
But this bias also refers to people who focus too intently on what they know. They become overconfident in their specific fields and fail to branch out, and as a result, their portfolio lacks diversity.
"For those that are overconfident, a lot of times it's because they feel very comfortable in a certain frame of what investing is," said Michael Liersch, head of Behavioral Finance for Merrill Lynch. "When you broaden the frame for them and say that investing is so much more, it reduces that to a more manageable level."
Bias: Feeling like you never know enough to make an investment
Underconfidence is exactly what it sounds like.
An underconfident investor doesn't believe in his own base of knowledge. Whether the legitimate rookie spooked by financial complexity or the perfectionist always chasing that Xeno's Paradox of complete knowledge, the underconfident investor always wants to know a little more before making a change.
The result is stagnation. Lacking confidence, this investor tends to sit on her holdings even when it would be a good idea to shake things up. Like a portfolio that lacks diversity, they become vulnerable to market shocks and downturns when the investor has too much inertia to respond.
Bias: Being too worried about risks to make gains
Even the best asset managers struggle to get risk balance right, and every investor should have a sensible cautious streak.
Loss aversion sets in when that caution becomes paralytic.
This bias is most characterized by concerns over investing in the wrong stock. Where an underconfident investor will set up their investments and follow that strategy forever and ever, a loss averse one won't have that sense of inertia. Instead, they constantly seek out safe harbors. A portfolio made up of Treasury Bonds and cash would be the ultimate expression of this bias.
What's the problem with that? Well, it's like the old saying goes: a ship in harbor may be safe, but that's not what ships are for. A bulletproof portfolio won't shrink, but it won't grow either.
Bias: Responding to whatever the latest news was, good or bad
After Solyndra, you abandoned green companies wholesale.
The auto bailout convinced you to buy up every share of Ford you could find.
Congratulations, you're a recentist.
Recency is the tendency to invest based on the last thing the investor heard about. At its best, it's an effort to stay on top of the market by moving into or away from fields dominating the news. That's a good instinct, but only up to a point. At the end of the day, it's probably best not to build a retirement account around rumors and a Facebook feed.
Bias: Going along with the latest hot trend
On a semi-related note to recency, we have the herd mentality.
This bias shows up every time an investor wants to jump in on the latest new thing. Staying abreast of trends is certainly wise, but that doesn't make those updates right for every portfolio. Learning about a shift in the market is, ultimately, only step one of a smart investment strategy.
"You can think about it," said Liersch, "as talking with friends and family and really being caught up in the moment and chasing investments that way."
"It eliminates the bespoke or personal aspect of it [investing], which is thinking about, 'What are my goals and what are my personal circumstances?'" he continued. "Chasing what other people are doing or what you perceive them as doing, which is what I think the more important component of this is, is what I generally coach people to avoid."
Bias: Reacting by gut instead of thinking something through
Investing can be scary. That's not news to anyone who rode out the Great Recession with a white-knuckled grip on his E-Trade password, but it's an endlessly valuable lesson. Short of a Treasury bond (see: Loss Aversion) every penny that goes into the market might not come out, and that can sometimes go to someone's head. He might want to jump at every new opportunity, or rush to protect his assets in the wake of a fluctuation.
Enter the trader who thinks too fast.
"That one is probably the most prominent tendency that we think through in our business," Liersch said. "Thinking too fast is this idea of really being very action-oriented in implementing ideas as quickly as possible in order to take advantage of opportunities. And that may be fine, and it may make sense in order to accomplish goals, but in many other situations you certainly have time to take a few day or even a few months to ask, 'Is this really what I want to do?'"
Bias: Seeking an investment because of a personal attachment
For retail investors, the stock market can often seem like an overwhelming place. Do you invest in mutual funds, options, stocks or bonds? Which sectors and companies look good? The sheer number of options makes it hard to know where to start.
Which is why many investors begin by seeking out a sense of familiarity. This bias shows up when someone sets their portfolio around the what they know from their personal or professional life. The doctor who invests in medical technology, for example, or the proud parent of an engineer who sinks it all into Pratt & Whitney.
There's certainly something to be said for the knowledge that familiarity breeds, yes, but that can be a double-edged sword. Just because a field feels comfortable doesn't mean it's safe (and those with industry knowledge, of course, should be careful lest they become overconfident).
Bias: Overreacting to a past experience, usually through avoidance
Here's a quick experiment: ask a few Millennials what they think about buying a house. Scratch much (at all) below the surface, and the smart money says that a lot of them will mention the real estate crash and watching people get locked into a property.
That's called learning too much.
This is the bias of taking a past experience with the market and turning it into an ironclad rule. An investor who took a beating once in tech stocks, for example, might never invest in the NASDAQ again. Another will watch Trading Places and never touch orange juice again in his life. It's not a bad thing, learning from experience, but it's also important to remember that one event doesn't dictate the future.
"Is that perception, or is that reality?" Liersch said. "Is that really the scenario to focus on, what's happened in the past, or should they look forward into the future?"
Compound interest, Einstein is said to have said, is the most powerful force in the universe. Here's hoping he's right, because it's the basis of the entire 401(k) social experiment.
It's an idea that a lot of investors have trouble incorporating into their strategies though.
Everyone can empathize with going for the big win. Selling off a position for five-figures of profit feels darn good, and is certainly a strong move when possible. However small, incremental gains are ultimately the bread and butter of a long-term portfolio.
Minimization is the bias of overlooking this and not seeing the value of rolling percentages, narrow dividends and boring profit models. It's not exciting, but that's ultimately where a lot of the real money is made.
Bias: Ignoring the personal aspect of investing to the point of regret
Here we are at the number one emotional mistake that investors make, and it is… ironically, ignoring the emotions involved with investing.
Lots of investors feel like they need to be robots, mechanically chasing the highest profit their portfolio will bear, but that's not true and it's not a sound strategy. Doing that risks making you, the investor, uncomfortable with your own money. That's not good for anyone's mental health, and you might wind up making poor or impulsive decisions because of it.
Take your feelings into account when it comes to investing. Make sure you're comfortable with where your money goes.
"Behavioral finance is about accepting the idea that we're all human," Liersch said. "If we're all wiling to be authentic about that, it could help us productively invest and help people get to better decisions."
It's O.K. to get a little personal about your money.