The ideal investor: How to keep emotional investing in check
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Emotional investing behaviors often prevent average investors from becoming ideal investors. The psychological factors of behavioral finance can help explain why investors often make buy and sell decisions that contradict investment best practices and rational investing.
By understanding the common investor behaviors that lead us astray, you can learn how to recognize and avoid these tendencies. Behaviors to be mindful of include the following.
Anchoring means creating a point that one uses to reference everything else. An example of this is when you might be house hunting and a realtor shows you a more expensive property out of your price range. You fall in love with that house and all subsequent houses are compared to it. However, was that expensive house the right anchor to affix your aspirations to? Perhaps not. In investing, anchoring can mean you hold on to investments that no longer fit your needs, or perhaps never fit your desires.
To address this anchoring tendency, force yourself to evaluate investments as if they are new purchases. Look at your investments and ask if you would buy that security today at that price. And, imagine if there was a malfunction in your accounts and all positions were liquidated. Would you repurchase all the same securities?
Herding refers to the idea that we seek out what others have done, which sometimes can lead to a negative impact, especially in investing. As investor guru John Templeton said, “If you want to have a better performance than the crowd, you must do things differently from the crowd.” The wise investor must take steps to ensure they are not following the trend or crowd.
To combat this, sit down with your advisor in a neutral market environment to set down guidelines of when to buy and sell investments. Ask your advisor to remind you of these guidelines when you make your decisions. Having this plan, developed in an impartial environment, gives you a strong foundation to weigh important investment decisions.
Mental accounting refers to the tendency for people to divide their money into separate accounts based on a variety of subjective reasons, like the source of the money and intent for each account. Individuals who do this have an often irrational strategy behind the separate accounts they create. Saving for a vacation in a special account, for instance, while also carrying a huge credit card debt is an example of this.
Don’t forget to look at the big picture of your entire investing strategy. Remember to look at both the bucket level and portfolio level. There are often opportunities to tweak a portfolio which may increase your return or lower your risk. Often you can implement these revised portfolios and still be comfortable at the mental account level.
Framing has to do with perception. Is the glass half full or half empty? This perception is usually colored by what is presented to us first. That is our point of reference and how we look at all things going forward.
In terms of investing, make sure you have established a mutually agreed upon frame of investment planning with your financial professional. Look at all scenarios and become educated on financial topics so you’re asking the challenging questions.
If you recognize these common missteps you’ll have the tendency to not repeat them. Be willing to critically challenge investment choices, even when times are good, and look for a financial professional that supports that approach.
Director of Investment and Retirement Education
Prior to joining BlackRock, Chad was the director of retirement solutions for The Principal Financial Group, specializing in retirement income and financial planning topics. His experience with The Principal included educational programs, marketing development and extensive platform presentations.
Chad received his Bachelor of Science from Upper Iowa University and his Master of Science from the College for Financial Planning. Chad is also a Certified Financial Planner (CFP®).