Avoiding Mental Traps When Investing

When the stock market tumbled into a bear market for the first 10 months of 2022, it marked the first downturn that many young investors had ever experienced. Meanwhile, many older investors suffered a decline in their retirement income as the bear market dragged on for much of the year.

This downturn, with the S&P 500 dropping about 25%, followed a historic bull market when the index gained over 400% between 2009 and 2020. These two market cycles demonstrated how investors can develop bad habits for different reasons.

With interest rates near zero during long stretches of the bull run, many investors – and perhaps some advisors – eschewed the buy-low, sell-high axiom and abandoned their investment plans to chase trends. When the bear market came, some investors and advisors then adopted the flip side of these bad behaviors by chasing returns to make up for the shortfalls.

Over the past few years, we have read about the get-rich-quick tales where investors threw money at so-called meme stocks like GameStop and Nvidia, or even tried to capitalize on a bull run in the cryptocurrency market that peaked in April 2021. But we don’t have to look at just the most recent data to see how investors can lose money by abandoning the buy-low, sell-high axiom and developing bad behaviors.

According to research by OneDigital, in the 20 years from 1996 to 2015, the average investor earned just 2.1% per year pretax, which did not even keep up with inflation, let alone the 8.2% earned by the S&P 500, or the 7% professional equity investors averaged.

At the root of many investor mistakes are the fears, biases and other common behaviors that undermine sound investing. As an advisor, it’s important to recognize these mental traps and help your clients avoid them.

Have a plan and stick to it. An investment plan builds peace of mind and allows you to track and achieve objectives. Without it, investors risk getting lost. Moving the goalposts, or chasing what’s hot, usually means that you miss both the best entry and exit points. This undermines performance and leads to anxiety, as you end up chasing performance too.

Avoid drama. There’s always the investor who stumbled, or gambled, on an investment that skyrocketed. Conversely, there are examples of those who choose poorly. Fear and envy can influence choices and paralyze the ability to stick to an investment plan.

Forget the fads. Trendy investments, especially those that log rapid gains, attract a lot of attention. But only for those who got in early, and out just as fast. Often, the gains in fad stocks evaporate and can lead to permanent losses of capital for those who didn’t get out before the jig was up.

Cast a wide net. When investors look at the stratospheric returns of buying Amazon, Nvidia or Apple 15 years ago, it can inspire people to bet the house on one or two hyped stocks. The problem is that big winners like that are not common occurrences. Even the proven statistical model of venture capitalists recognizes the need to buy stakes in 20 high-potential vehicles so that they achieve enough success on the one or two that make it big to offset the losses on most of the holdings that fail. The statistics are better with large cap public companies, but the directional trend is the same. To net the heroes that make the whole game worthwhile, most funds need a big enough pool of fish to avoid missing out on positive returns altogether.

Trust your IQ and EQ. As advisors, it’s important to condition clients to develop better habits by using both their IQ and their emotional intelligence to avoid falling into the mental traps mentioned above. Encourage clients to:

-Not worry about things they cannot control.

-Avoid probability weighting since the tendency is to overweight low-probability outcomes and underweight high-probability outcomes.

-Identify actions that can reduce their risks and raise returns.

-Always conduct solid diligence before investing instead of relying on the “wisdom” of talking heads.

Investors, especially those who are new to investing or don’t invest professionally, can get caught up in the noise coming from talking heads on cable TV or online. They can develop bad habits and fall into mental traps by listening to the noise instead of doing solid diligence before investing. As advisors, you can help your clients develop good investing habits that make them less susceptible to mental traps that can destroy their returns. By creating an investment plan with your clients, they will be empowered to navigate the peaks and valleys of the markets with confidence.

Eric Beyrich is co-chief investment officer at Sound Income Group, a financial services firm.

At the root of many investor mistakes are the fears, biases and other common behaviors that undermine sound investing.
By Eric Beyrich
January 24, 2024