Ultimately, successful investing over the long term has a lot more to do with suppressing emotional reactions than it does with maximizing any intellectual gifts one may have. Psychology as it relates to investing is an important yet somewhat underrated topic, and when you recognize the psychologically-based issues that can adversely affect your long-term investing success, that can prove to be an important first step to improving your returns. This is a fascinating topic characterized by some complexity, but for purposes and scope of this blog article, I wanted to discuss three of the more prominent psychological roadblocks to winning at investing…loss aversion, confirmation bias, and optimism bias…as well as spend some time discussing how the average investor might best mitigate their effects.
Practically everyone runs the risk of being negatively impacted by loss aversion, such is the nature of the human mind. In terms of investing, loss aversion principally manifests itself in two important ways. First off, many people have a great deal of psychological difficulty locking in losses. I know someone, an otherwise-bright fellow, who toiled in shares of Bank of America for the last several years simply because he could not bring himself to lock in what had become his losing position. Of course, taking his proceeds and moving on to any of the other countless stocks that have done very well (which he has since done, but much later than he should have) in the time he was hanging on would have been the superior option, but he has great difficulty bringing himself to pull the trigger on a position while it has a negative symbol sitting in front of the number reflected in the Gain/Loss category. One element that makes this even more challenging for those inclined to submit to loss aversion is when the security over which they’re obsessing is a higher-quality issue; while loss aversion can be a problem even when the security is a penny stock, the role it plays is not as significant, because even the investor plagued with a great deal of loss aversion can see his way to accepting the futility of his stock position when it’s a no-name company. However, when it’s a big company, like a Bank of America, fighting loss aversion is more difficult because of the inherent quality; the thinking goes like this: “Well, it has to come back at some point…it’s Bank of America, after all.” The problem is that even if a stock does come back, the time that has been wasted while mired translates into much more lost than necessary.
Another relevant aspect of loss aversion is that people derive greater pain from losses than they do pleasure from gains. Any investment adviser will tell you that he never hears from the customer who’s up 5% in his portfolio and wants to express how happy he is to be up 5%, but that he will absolutely hear from that same customer when he’s down 5%. This form of loss aversion can manifest itself by prompting an investor to retreat to overly-conservative instruments that, in the long run, will significantly hurt his chances of achieving his wealth objectives. For example, it would be impossible to count all the investors who have waded into equities markets at one point and subsequently decided that the volatility, even when situated in low-beta securities, was such that they wanted to be back in “something that just doesn’t move.” They shift back to where they were previously, perhaps to a money market or an ultra short-term bond fund, and that’s that…both in terms of their worry, but also in terms of the likelihood that they’ll eventually achieve their long-term objectives.
Confirmation bias refers to the tendency of people to embrace and act upon information that confirms their existing beliefs, and, just as importantly, to reject information that sits in opposition to their existing beliefs. Outside of investing, we can easily identify examples of confirmation bias influencing many aspects of our daily lives, so prevalent is it – the inclination to want to believe only the best about friends, even when reliable information emerges to the contrary; the acceptance of positive reviews about a long-desired automobile while simultaneously marginalizing the negative ones; and on and on.
When it comes to investing, confirmation bias can reveal itself in different ways, but one of the most prominent is the processing of news and information about a stock, mutual fund, or sector in which we’re invested in such a way so that we remain with it, and thus happy about our original decision to purchase it, even if the information contravenes the wisdom of doing so. The bottom-line effect of confirmation bias is that helps to convince us to purchase and/or remain with securities we should otherwise be leaving behind.
Optimism is a funny thing. On the one hand, it serves us well to be optimistic, for reasons that need no real explanation. On the other, it can obscure our outlook in such a way so that we don’t see the world as it really is, and when that happens, it can affect the objectivity and legitimacy of our decision-making processes. In a nutshell, optimism bias is the tendency to believe that bad things will happen only to the other guy; examples of optimism biases include the avid motorcycle rider who believes that the horrible accidents that befall other riders will never happen to him, the poor student who believes that somehow everything will work out and he will still pass his classes, and, in the case of investing, the guy who believes that the investment decisions he makes will serve him well because it is he who made them. The chief consequence of optimism bias for the investor is that he will remain with a security, a sector, or even in a market too long because he, like the poor student, believes that when it comes to him, everything will just work out.
To reiterate, each of these issues can be problematic alone, but they can also work effectively in concert with one another to be even more constraining on investment success. For example, the aforementioned Bank of America investor would also make anecdotal mention of any scrap of good news about a prospective recovery that would emerge on behalf of the company or the financial services sector, and that element of confirmation bias undoubtedly helped to feed his loss aversion.
There is no real trick for overcoming these psychological obstacles, just as there’s no trick or special technique for overcoming the host of other psychologically/emotionally based issues that can intrude into our lives, other than recognizing them and willing ourselves to respond differently and more productively, going forward. The first key to overcoming them is awareness – real objectivity can be tough for anyone to achieve, but it’s not impossible to at least get into the ballpark, and constantly working to remain aware of these minefields is an important first step.
The second step is to try to systematize your investing, as much as possible, given your investing type. If you are a less-active investor, someone who is more prone to buying and holding (despite telling yourself that your days of doing that are permanently behind you), then create an investing paradigm for yourself that favors your chances of succeeding that way without regard to any psychological obstacles. For example, perhaps if you resolve to do your investing entirely through low-cost ETFs, creating a portfolio of those that keeps you well-diversified and systematically averaging yourself in each month, come hell or high water, then you give yourself a much better chance of succeeding over the long term. If you are an active trader, you may be more prone to the intrusion of these psychological issues, simply because you will have reason to more frequently consider your investments. In your case, once you have established good parameters for your various screens, stick to them; trade in the way they tell you to trade. This doesn’t mean you should not adjust those screens if they appear to be poor or become less relevant based on changes in economic and/or market conditions; you should, of course, and that is one of the ongoing burdens faced by the active investor out of deference to his belief that more active investing is more profitable, but adhering to your screens and systematic methodology will go a long way to helping keep your psychological demons at bay.
Ultimately, the point is to be able to recognize the impediments to psychologically “clean” investing, and then create a system, based on your investing type, that allows you to mitigate those impediments as much as possible. Of course, backstopping all of this is your base inclination to remain, or become, as disciplined as possible. Minus that, nothing will work, but with that, your returns, aided by your collateral systems, will give you the best chance possible of achieving long term success.