Financial discipline is imperative to the success of your long-term investments. But your behavioral biases can get in the way of that long-term success. Biases allow you to be short-sighted and you forget about the big-picture consequences of your actions. What are some of those biases? How do you avoid them and make sound investment decisions? I talk about 6 behavioral biases in this episode of Best in Wealth. Don’t miss it!
Outline of This Episode
- [1:07] Leave Best in Wealth a review!
- [2:13] Personal + financial discipline
- [4:28] The definition of discipline
- [7:13] Behavior #1: Herding Behavior
- [9:30] Behavior #2: Overconfidence
- [11:48] Behavior #3: Myopic Loss Aversion
- [13:29] Behavior #4: Recency Bias
- [16:05] Behavior #5: Home Market Bias
- [17:58] Behavior #6: Disposition Effect
- [19:58] What is your punishment?
The Definition of Discipline
According to a quick internet search, discipline is “The practice of training people to obey rules or a code of behavior using punishment to correct disobedience.”
Investors often think that they are disciplined, right? But the truth is that most of us are not good investors. That is why you must practice discipline. But we all deal with behavioral biases that impact our investing experience. The following are 6 behaviors that can affect your investment returns.
Behavioral Bias #1: Herding Behavior
One word: Bitcoin. We are hard-wired to look to others for the right way to behave. The problem is that this leads to a lack of independent thought and evaluation. You see Bitcoin continue to climb because of supply and demand. We feel like we need to follow the herd and buy into Bitcoin now. But it means you are chasing the returns. If you buy in at $50,000 and the market corrects, you may be down thousands of dollars. If you look at stocks as a whole in the last 6 months, there are so many better places you could have been than technology stocks.
Behavioral Bias #2: Overconfidence
Overconfidence bias leads investors to overestimate their knowledge and ability—while underestimating risk. We think we are smart. But it is nearly impossible to outsmart the market. Only about 25% of actively managed funds beat their index. The efficient market hypothesis states that stock prices reflect all market information. Remember one thing: everything that we know about a company or sector is already priced into the market. If you are not diversified, you are pinning yourself against millions of investors. Overconfidence can kill your portfolio.
Behavioral Bias #3: Myopic Loss Aversion
Loss aversion means that investors are more sensitive to losses than gains. This occurs more frequently when investors check their performance every single day. Oversensitivity creeps in when you do that. This causes investors to behave irrationally and sell after a market drop which means taking a loss. When you feel good about a market gain and then see a loss—it hurts twice as bad. It makes us irrational about our money and we lose subjectivity.
Behavioral Bias #4: Recency Bias
People—including me—have short memories. We recall recent events more clearly than those in the past. It is especially dangerous in investing. We forget about prior market declines. We take more risks when things are going well. We are overconfident and following the herd behavior. Then we see things dive 20–30%. The same holds true when the market is doing poorly. We want to reduce our risk and attempt to time the market. It is causing problems in your portfolio. You are not disciplined.
Behavioral Bias #5: Home Market Bias
As investors, we have more than 90% of our money invested domestically—even though the US represents only 50% of the global market cap. We are not as diversified as we could be because of home bias. People like to hold their own company stock. We think we know more than the next guy or gal. We are overconfident because we “know” this company. When we have home market bias, we hold more company stock than we should. Or we hold stocks longer than we should. You have to remember that millions of people know the same stuff you do.
Behavioral Bias #6: Disposition effect
Investors hate admitting that they are wrong and even worse—taking a loss. Because of this, we tend to hang on to losers all the way down. Our overconfidence can lead to taking too many in the market. Your portfolio may have dropped quickly. You feel like you have to hold even though you are beyond your risk level. You hold on to hope that the market will ride back up. The losses hurt.
All of these behavioral biases work together to make it difficult to stay disciplined. This is what happens when you do not have a written plan. You are not as disciplined as you think you are. When all of these biases are working together you are not getting what you should from your investments.
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The Best In Wealth Podcast is hosted by Scott Wellens. Scott Wellens is the principal at Fortress Planning Group. Fortress Planning Group is a registered investment advisory firm regulated by the Securities Act of Wisconsin in accordance and compliance with securities laws and regulations. Fortress Planning Group does not render or offer to render personalized investment or tax advice through the Best In Wealth Podcast. The information provided is for informational purposes only and does not constitute financial, tax, investment or legal advice.