Recessions are terrifying.
Market crashes often bring out the worst in people’s anxieties and fears.
This fear triggers us to act even more irrationally than usual – which can lead to making expensive mistakes in our investment portfolios.
In today’s episode, Scott Nations, who spent his career studying market volatility, describes some of the most common cognitive biases and irrational behaviors that investors make. He shares tips on how to master the mental game of investing, especially in turbulent times.
Here are a few irrational biases that destroy wealth:
#1: The disposition effect – Humans have a tendency to sell their winners and hold their losers.
Why? We get a dopamine hit when we sell a winning asset and lock in our gains. Meanwhile, sunk cost fallacy makes us want to hang onto the loser ‘until it comes back.’
How can we avoid falling prey to this?
First, if you’re thinking about selling off an asset that’s performing well, ask yourself: What’s the real motivation? Do you want to book a profit for the sake of booking a profit? Or do you believe that some underlying fundamental has changed?
Next, compare this decision to your investor policy statement, which is your written statement about your goals, timeline, risk tolerance, risk capacity, strategy and style as an investor. Is this decision aligned with your written personal policies?
#2: Status quo bias – Our tendency to overvalue our current situation, such as the mix of assets that happens to already be inside our portfolio. We demand a higher burden of proof to justify any change than we do to justify holding the status quo.
This is often triggered by information overload – when we feel overwhelmed by excess information and too many options, we react by doing nothing.
Psychologist Barry Schwartz calls this the “paradox of choice” – the more choices we’re offered, the more likely we are to not make any decision.
How can we protect ourselves from this? One tactic is to adopt a low-information diet, in which we carefully curate the amount of news and information that we receive.
Another tactic is to look at our resources and imagine that we’re starting from a blank slate. If we didn’t have our current mix of stocks, bonds, real estate, crypto, etc. – if we imagine that we’re starting with our entire net worth in cash – how would we allocate our capital if we were starting from scratch?
#3: Overconfidence – Research shows that people consistently overestimate both their abilities and their predictions of positive future outcomes.
The majority of people think they’re an above-average driver, which is mathematically impossible.
Most people overestimate their probability of getting and staying married forever, of not grappling with fertility issues, choosing a winning investment, or becoming a millionaire.
Today’s interview guest says that he’s aware that, among all the cognitive biases he describes, he’s personally the most susceptible to overconfidence bias. Staying aware of his personal susceptibility helps him keep it in check.
#4: Loss aversion – The sting of a loss is more emotionally profound than the joy of a gain. As a result, our brains are hardwired to avoid losses, rather than pursue gains.
This closely relates to the sunk cost fallacy that fuels the disposition effect, which we described above.
We describe many more cognitive biases in today’s episode. Enjoy!