No matter how smart or educated you are, and no matter how successful you are at work, when it comes to investing, you may not make the best decisions.
It’s because you’re human, which means you react in certain ways that serve you well in many areas of your life, but work against you when it comes to decision making. smart investing, according to psychologist Daniel Crosby, author of “The Behavioral Investor”.
“Not only is high intelligence not an insurance [against poor financial decisions], it can be a red flag,” Crosby said. But here’s the thing: if you know your mediocrity when it comes to the market, it can really help you be a better investor.
Based on decades of critical behavioral research, Crosby says that entrepreneurs fall prey to four internal assumptions. But when you know them, you can do something to reduce their impact or use them for your money.
Everyone has ego. It protects us in many ways, in part by creating a sense of confidence – and often – in our own abilities and judgment.
“Ego gets us out of bed in the morning,” Crosby said.
People who are confident are more likely to find inspiration and success in their careers. “People who are always confident are always happy, they are likely to do well in business and politics. And [ego] can protect us from setbacks, disappointments and losses,” he said. But when it comes to investing, overconfidence can cost you dearly.
For example, Crosby said, most of us would rather find information that supports what we already believe than seek information that challenges our beliefs. He referred to studies that show that even if we are presented with facts that are contrary to what we believe, because of the money we have in our body, we can take root in those mistaken beliefs.
One way this can happen when investing is that you can be sure that a new company or class – like crypto – will win in the future. So you throw in unlimited amounts of money and your ideas won’t go to waste.
But research shows that choosing what you think will be future winners instead of investing in larger stocks can hurt your long-term returns. Crosby cited statistics showing how managed equity funds performed worse than passive investments more than 80% of the time over a five- to 10-year period. And that’s before you factor in ‘high fees that an investor pays for a well-managed fund.
Investing always carries risk. However, individuals may take on too much risk by clinging to their prior investment decisions or basing their choices off of proverbs such as “invest in what you know.”
According to Crosby, an individual who lives in a city with high concentrations of technology workers and invests primarily in tech stocks is at risk for disproportionate financial losses when the tech sector experiences difficulty.
Rephrase Investors often default to investing in U.S.-based stocks, believing that non-U.S. stocks are too risky
Humans tend to pay more attention to bad news or scary, impossible events (like a shark attack or a plane flying into a building). Both can distort our perception of risk. In addition, too much information – whether from data, research or reports – can lead to wrong decisions, while too much information makes it difficult for trees to identify forests, Crosby said.
Our feelings and thoughts can protect us in some difficult situations, or they can guide us. For example, you may end up choosing the right partner after years of being singled out by others. But they can also cause us to be cautious now and cancel what we know we should be doing.
Think donuts, Crosby suggested. You may have been given diet advice all over the world, but under extreme pressure, you’ll always want powdered donuts, not asparagus.
The emotional approach to marketing can be expensive. If your music is working, you might panic and sell at the wrong time. Or if you’re happy, your optimism can cloud your view of the risks you’re taking on your investments.
Plans to beat back our biases
Investors may want to overcome their different perspectives in different ways, Crosby said. Among the plans he suggested:
Turn off the noise. Don’t check your investment account every day. Any changes in the market have been fixed. Do not measure water in metric. And don’t let negative events influence your investment decisions the wrong way.
Be humble. You can’t predict the future. You may not have enough information to make a good bet on a particular security or sector.
Organize your different holdings. Crosby puts it this way in his book: “Invention is … in the form of risky money management. [It] is a clear reference to luck and uncertainty in money management and the recognition that the future is unknown.
For example, to prevent the so-called housing bias in your investment, Crosby recommends not to invest more in housing stocks than their percentage of the world market. Depending on how they are measured, US stocks make up between 45% and 60% of the global stock market.
But the average investor in the United States tends to have a large portion of their stock in US companies and a small amount in foreign stocks.
Have an ordered system. Balancing your money and investing in a diversified portfolio, regardless of market conditions, often works well. The same goes for automatically setting aside some savings for short-term purposes and emergencies.
“It’s less about having a perfect system than having a system,” Crosby said.
An example is the “set it and forget it” concept in retirement funds. Employees who choose options in their 401(k) plan will increase their savings each time they make a raise rather than making monthly decisions about how much to save.
Use emotions to get the most out of your money: A study Crosby cited showed that low-income parents were twice as likely to save money when they had an envelope containing a photo of their children.
Know that no investment is perfect. Many people get their exposure to the stock market through a 401(k), especially through target date funds that are offered by their employers as passive investments.
While target date funds have their detractors, Crosby said, “Not every investment is perfect. …And [the expected income] is much better for the average than what everyone does.