Please don’t take this personally, but Benjamin Graham was correct when he said, “The investor’s chief problem–even his worst enemy–is likely to be himself.” But this is nothing new. Back in the day, when it came to making important financial decisions, Greeks undertook the dangerous trek to the Temple of Apollo.Upon arriving at the temple, they would seek the advice of the Pythia, commonly referred to as the Oracle of Delphi. Deep within the cavernous Temple of Apollo, the Pythia would inhale intoxicating gases, sending her into a drug-induced state of euphoria. She would transfix her eyes on her subject, then dispense advice on literally everything, from how to create wealth to healing ingrown toenails. Many believed that the Pythia had been anointed by the god Apollo as his alter ego, perhaps explaining why her voice was that of a man.
Although this may very well be an old wives’ tale, it underscores how investors can be hoodwinked into believing outlandish myths and claims. And there are a number of behaviors that investors engage in that, unfortunately, conspire to keep them poorer. Here are seven of them:
1. The Herd Mentality
The herd mentality is where investors subconsciously follow what other investors do. For example, the herd mentality was front and center when the dot-com phenomenon emerged in 2000.
The herd mentality is primarily caused by the financial media and their propensity to create fear through salacious headlines and fear-mongering. The old saying, “If everyone is doing the same thing, it must be right,” does not typically apply to investing, and that’s because, unfortunately, the majority of people don’t know what they are doing.
If you can succeed at avoiding what the herd does, your chances of becoming wealthy are far greater. This takes discipline on your part and a conviction that your portfolio is in your long-term best interests. Trying to hit “home runs” by buying the “flavor of the day” stocks will have you in the poorhouse in just a matter of time.
2. Transgenerational Trauma
Some bad investor behavior can be attributed to “transgenerational trauma.” This is where trauma caused by economic issues, geopolitical forces, and stock market volatility is passed on from one generation to another, much like DNA. For example, the Great Depression of the late 1920s and early 1930s caused an unprecedented collapse of the stock markets, high unemployment, plummeting income, and corporate profits, and a great deal of angst and trauma.
Unfortunately, traumas such as this, and others ranging from pandemics to world wars, have become the foundation for millions of families’ investment attitudes, many of which have and still conspire to keep people poorer.
It would appear that there are going to be issues with many millennials as it pertains to creating meaningful long-term wealth. As reported in Wealth Professional magazine on May 19, 2021, “…about one in 10, or 3 million Canadians say this will be the year they will stop working with a financial advisor to manage their investments, according to the latest research from the financial comparison site Finder.com.”
This change in investor behavior is serious for several reasons, including historical research that clearly concludes that do-it-yourselfers typically fail at investing. The most cited reasons for getting rid of an advisor were savings on fees and having more control over their money.
The notion that saving on fees will mean more money upon retirement is one that is steeped in misinformation. While reducing fees is always welcome, the notion that getting rid of an advisor means creating more wealth is contrary to many studies that show having a quality advisor actually means creating more wealth, not less.
3. Loss Aversion
Loss aversion is defined as a person’s tendency to prefer to avoid a loss over receiving a gain, even if the outcome is exactly the same. According to several studies, loss aversion is very common when it comes to making financial decisions.
Perhaps you have heard the old saying, “It’s better not to lose a penny than to make a penny.” This cognitive bias traps many investors into making bad financial and investment decisions. For example, an investor may be less inclined to buy a stock if it’s perceived to be risky, even if the reward for potential gains is high. Instead, they prefer to invest in perceived low-risk investments such as products that “guarantee” their principle back at some point in the future.
What they don’t realize is that, very often, these sorts of investment products actually become high risk the longer they own them. Because the returns are so low, when coupled with inflation and taxes, millions of investors realize too late the error they made, and many unfortunately just get by in retirement.
4. Risk Aversion
Risk aversion is a combination of investors’ greater sensitivity to losses than to gains and a need for investors to constantly evaluate their investment returns. Studies have shown that investors who receive more information more frequently take the least amount of risk, resulting in lower investment returns! Unfortunately, the investment industry unintentionally promotes risk aversion by whacking clients over the head with monthly statements. Advisors alike unwittingly contribute to their clients’ aversion to risk by insisting on regular portfolio reviews.
Overconfidence is another behavioral tendency whereby some investors tend to be overconfident in their investment capabilities. Among other things, they engage in market timing and day trading, and typically these investors always brag about their successes; rarely do they talk about their losses.
Representativeness is an investment behavior where, upon hearing news about a stock that he holds in his portfolio, an investor perceives it to mean something completely different from what it does. For example, let’s assume that you own Apple shares. You receive notice that an analyst has downgraded the stock. Fearing the worst, you decide to sell your shares. Even at a loss, however, the analyst was downgrading the stock due to a temporary situation, which you mistook as something serious.
7. Frame Dependence
Yet another investor behavior, frame dependence,is when an investor will change their risk tolerance based on the direction of the stock markets. Typically, investors tend to have a greater risk tolerance when the markets go up and lower risk tolerance when the markets come down. For example, Susan decides to invest $50,000 in five quality stocks as the markets have been rising. She informs her advisor that her risk tolerance is medium. A couple of months later, her stocks take a dip, and she begins to panic. Her risk tolerance suddenly changes from medium risk to low risk because she is basing her investment decisions on how the situation at hand is framed rather than the actual facts of the situation.
It’s by understanding your own human behavior as it applies to your investment decisions that will either make or break your ability to become wealthy. By harnessing your emotional biases and by understanding why many investors succumb to irrational behavior, these actions will undoubtedly provide you with a much greater probability of investment success.