3 Investment Mistakes to Avoid

The hardest part of investing isn’t understanding the numbers–it’s understanding our own psyche.

Ideally, when we’re making decisions, we’re making purely rational decisions based on the best available evidence. But the reality is that various biases, often unseen or unacknowledged, shape each decision we make.

When the stock market gets bumpy, it’s easy to fall into cognitive traps that encourage you to make bad decisions.

I’ll explain the three that I see most often and what you can do to manage them.

Overconfidence Bias

Many people believe that they can beat the market because they see the angles that everyone else is missing.

Confidence doesn’t correlate to competence.  Even investment analysts with years of research experience make mistakes.

When the stock market shows signs of volatility, people often pull all their money out. They believe they see the oncoming storm on the horizon.

But this is often a money-losing endeavor. Once their money is out of the market, they won’t reinvest until the market is doing much better, meaning they’ve managed to sell low and buy high.

Keeping your portfolio diversified is usually a better approach than hoping we see things others don’t in the market news.

Confirmation Bias

When making a decision, we tend only to see information that confirms what we already believe.

If we think Apple is a terrific company, we unconsciously tune out bad news about the company. Instead, we focus on the good news that supports what we already believe.

A lot of people were still buying BP stock while the Deep Water Horizon was spilling millions of gallons of oil throughout the Gulf of Mexico.

Is BP a good stock? Maybe. Was it a good choice in May 2010? Probably not.

We can’t make good decisions without weighing the good against the bad. Confirmation bias nudges us to conclude that what we already believe is true.

Recency Bias

We tend to project recent events or performance into the future. For example, if international stocks have underperformed U.S. stocks over the past five years, we assume that trend will continue for the next five.

Toward the end of the dot com boom, many investors got burned. Even when they saw market volatility, they assumed it was temporary and that the tech-fueled bull market would continue.

It’s wise to remember that the market is always in flux. You should expect trends to end. The best way to protect yourself is invest in a well-diversified portfolio. When you combine stocks and bonds, big companies and small companies, high growth and low growth stocks, international and domestic companies, you protect yourself against the unknown events just around the corner.

Knowing Your Limits

Given how vulnerable the human mind is to these bad habits, what can you do to protect yourself?

The most important thing: keep your long-term goals in mind.

When the stock market gets rocky, it may be tempting to sell off all your stock and leave it in cash until the stock market improves. In my experience, selling your stocks is the easy part. It’s knowing when to get back into the market where most people struggle.

If you don’t plan on retiring until 15 years from now, will today’s market volatility even matter? Or do you expect the stock market to be able to recover in the next decade and a half? To put it another way, do you remember how the stock market performed 15 years ago? If you would have sold out of the stock market then, when would you have felt comfortable enough to get back into the market?

If you’re not sure what to do, run your decisions by an advisor. Professional advisors, especially fiduciaries, can provide some perspective.

Finally, if you are prone to making emotional decisions, remember that you can always hand over the reins. You have a few options.

You can hire a professional to take on the burden for you. Professional management fees have come down in price over the last few years. Some management programs cost under 0.50%–a small price to pay to protect your retirement savings.

Pulling It All Together

Try as we might to make rational decisions about the stock market, our emotions and biases sculpt our decision-making process.

Our emotions make us human. No one expects you to be a robot when weighing financial decisions.

But for any investor, it’s crucial to understand how the limits and pitfalls of the human psyche impact our ability to make sound financial decisions.