Successful investments depend as much on mental fortitude as on sound strategy. More often than not, people succumb to a handful of cognitive biases that rationalize emotionally-charged decisions and result in underperforming investments, lost opportunities, or both.
Recognizing and understanding these biases is integral to combating the urge to take action when flooded with fear or excitement; selling all of your holdings during a market dip in a desperate attempt to avoid loss, for example, or falling prey to eagerness when hearing of a shiny new stock that has caught the attention of your friends and family.
In this guide, we’ll introduce five cognitive biases investors commonly fall prey to, and what tools you can use to combat them. Then, we’ll tackle the importance of creating goals that are unique to you, as well as planning exit strategies to realize them.
The Power of Long-Term Investing (and Obstacles to Starting Early)
The first decision any potential investor is faced with is when and where to make their first investment. With the amount of (sometimes contradictory) information available, figuring out how to start can be overwhelming, and often results in people putting off investing entirely out of fear of making mistakes.
But not investing at all, or starting to do so late in your career, is the biggest mistake of all. Money sitting in the bank depreciates with time due to inflation, while money invested can appreciate exponentially. And the earlier you start — the more time you give your money to grow — the better.
Say you were to invest $20 per month with an 8% average yearly return. What would be the difference between doing so over a 20-year period, versus a 10-year, and 5-year period?
Over 20 years that monthly $20 would snowball into $11,780. That is nearly 3x what you would have made in a 10-year period ($3,659), and 6x the return of a 5-year period ($1,470).
The math is clear: investing even a tiny portion of your monthly paycheck every month for a long period of time can result in significant wealth, with little risk. Then why don’t more people invest, or fail to start investing early in their career?
The answer lies in the first of five cognitive biases: hyperbolic discounting.
Combat Hyperbolic Discounting by Chunking
Hyperbolic discounting means we tend to value immediate, smaller rewards over greater rewards in the future. Put in practical terms: it is easier to remain in your comfort zone instead of trying to root through endless information on investing in an effort to orient yourself. It is easier to focus on smaller financial goals, such as paying off student loans, that may cause stress in the present but ultimately offer no long-term gain.
Delayed gratification is challenging — while identifying what you need now is easy, most people struggle to imagine what an intangible, future version of themselves would need. Between that and not knowing where to start, it is no wonder why so many people stay put and forgo investing altogether.
Fortunately, you can combat the Hyperbolic discounting bias using a strategy called Chunking.
Chunking is a technique that helps you build momentum (financial, or otherwise) by breaking down large decisions into smaller, easier-to-manage ones.
In practice, chunking can be quite simple: Instead of trying to learn everything there is to know about the market before you invest in your first stock, choose one small aspect to study, such as finding more information on the S&P 500. Then, and only after you’ve understood how the S&P 500 mens, you can worry about whether making an investment would be a fitting next step.
Chunking works best when you automate as many of these smaller decisions as possible. Automating decisions, such as setting yourself a deadline to move a certain amount of money into your brokerage account at the end of each month, allow you to reduce decision fatigue, which in turn helps combat hyperbolic discounting.
Reframing Risk as Opportunity
Earlier, we mentioned the common pitfall of giving into fear following dips in the market. Markets can fluctuate considerably depending on what is happening in the world, and while it is normal to feel nervous about these swings, such negative emotions are ultimately unhelpful and can get in the way of making smart investments. Increasing your mental strength will help you be emotionally prepared for inevitable changes in the market.
A second cognitive bias to look out for is risk compensation. People fall prey to the risk compensation bias when they take bigger risks during a perceived increase in safety. Unfortunately, this mindset rarely results in significant gains, and can lead to numerous missed opportunities for investment.
So how can you keep calm when faced with the chaos of the markets?
Reframing relies on a perspective change to assess a situation in a new light. To be emotionally prepared for a rollercoaster of potential gains and losses, you must accept the risks associated with investing. You cannot control the markets, and coming to terms with this will make it easier to see past the fear of uncertainty.
There are techniques you can use to successfully reframe your perspective on investing, and the risks associated with this practice. Developing clear, personalized goals, for example, is an important way of grounding yourself when working with elements outside of your control.
“Making money” is a vague aspiration. What is it all for? Are you hoping to retire comfortably? Buy a beach house? Build generational wealth? Visualize yourself achieving these goals whenever the discomfort of market uncertainty sets in.
Another way to gain perspective and reframe risk is by leaning on history during volatile times. While we cannot predict what the market will do with certainty, there are patterns we can look at to inform our decisions.
For example, fall has been a historically tumultuous time for the markets. For the last 70 years, the S&P 500 has dropped consistently in September, making it the worst month of the year on average.
In the same time period, October has demonstrated the highest levels of volatility, every single year. Keep this information in mind when next you feel the urge to buy or sell during these months, and study financial history to find patterns where similar things might be taking place.
Competence vs. Confidence: The Dunning-Kruger Effect
Mental setbacks accompany feelings of discomfort, so it’s important to train yourself not to act on negative emotions when investing. But bare in mind there are risks associated with overconfidence as well.
The Dunning-Kruger Effect is a third cognitive bias, in which competence and confidence have an inverse relationship. Paradoxically, the more you know, the more you realize how much you don’t know. In the context of investing, there can be a naivité present at the beginning of your financial journey that makes you underestimate the complexity of the markets. As you gain experience, and realize the extent of this complexity, your confidence drops.
It is very important not to get carried away by the supposed ease of investing, underestimating the role of luck in initial gains. No one can really claim to understand the market, and so we must work to mitigate overconfidence.
Find the Sweet Spot between Confidence & Competence
Finding the balance between confidence and confidence necessitates checking your ego. The market is constantly changing and you need to adapt alongside it. One great way to do this is by staying engaged and informed.
You might also want to avoid putting all of your eggs in one basket by rebalancing your portfolio. Shifting some of your assets from hot positions to less favorable ones will help avoid complete loss should market conditions change.
In a similar vein, diversifying your portfolio, as opposed to trying to bet on the next winner, is another strategy for success.
When you look at Wall Street’s asset class charts spanning 20 years, you’ll notice that each asset class had led for at least one year. You’ll also notice that a 60/40 portfolio—containing 60% large cap stocks and 40% bonds—has consistently average performance.
Why is this a good thing? Well, consistently performing sub-optimally instead of experiencing major losses and gains creates a feeling of safety. You’re more likely to make informed decisions when not on an emotional rollercoaster.
As a final note on establishing a balance between confidence and confidence, try to invest in what you know. Understanding a stock’s intrinsic value gives you a starting point when analyzing your positions, instead of groping blindly in the dark when investing in a stock for which you have no background knowledge.
Resisting Peer Pressure: The Bandwagon Effect
In the age of social media, it can be hard not to know what your friends and family are doing in most aspects of their lives, including regarding their finances. On the one hand, we’ve seen an increase in accessibility and financial knowledge as investing has become normalized in our social circles. At the same time, it’s easier than ever to follow investment trends in your community while neglecting your personal goals.
The Bandwagon Effect, as you can probably infer, is a cognitive bias in which you believe things based on the number of people who share in the belief. Echo chambers can be loud, and yet another essential aspect of building mental fortitude involves not succumbing to the pressures created by your immediate community. It is unlikely that folks broadcasting the latest “hot tips” will disappear anytime soon, so it is a good idea to learn how to block out the noise sooner rather than later.
Trust Your Goals
Resist peer pressure by remembering why you started investing in the first place. In other words: trust your goals. This is a good time to visualize that beach house again, or the look on your childrens’ faces when you tell them they don’t need to take out student loans for college. Your goals serve to keep you focused and motivated. When you are tempted to trade on feel, remember why you’re doing this to begin with.
Make a plan and stick to it. Your goals need to fit into a plan for achieving them. Two things to consider when creating such a plan are time frame and risk allowance. You cannot hold onto your positions forever, and you need to decide what conditions you are prepared to weather until it comes time to exit.
3 Simple Exit Strategies
Exit planning can be complicated, but there are three simple approaches that can be used as a guide for creating concrete plans for reaching your goals: (1) time goals, (2) price goals, and (3) return goals.
When choosing an exit based on a time limit, you decide to hold a position for a certain number of months or years, after which point you will re-evaluate your position and goals.
With a price-based exit, you plan to hold a position until the share price reaches a certain dollar amount. Equally important is setting a lower boundary for this exit, meaning that if the share price falls to a certain amount, you will take it as a sign to sell.
Similar to setting price-based exits, when deciding on an exit based on return, you set upper and lower boundaries for the percentages of returns at which you would continue to hold. Any higher or lower, and you move to sell.
All of that said, try not to feel cornered into a particular plan. Your plan is here to help you, and more importantly, your goals can change. It is important to have something concrete to work towards, but re-evaluation is part of the process. What “enough” means for you can change based on circumstance.
Digesting Headlines & Assessing Impact: The Ostrich Effect
There is a lot of information out there. It is easy to become overwhelmed by headlines and want to avoid negative information by metaphorically burying your head in the sand.
The last bias we will be addressing is the ostrich effect, in which we avoid negative information by pretending it doesn’t exist, a common example of this being not checking your credit card balance to allow for room to pretend it may not be high.
When reading headlines, evaluate information objectively by considering it in the context of your goals. As we mentioned before, current events are unlikely to impact long-term goals.
Don’t overreact. Accepting the unexpected, and remembering that your goals can change with the circumstances of your life are perspectives that will ground you when digesting new information. Keeping calm will allow you to process and adjust as needed.
Continuing to stay engaged and open, and resisting the impulse to make decisions when emotions run high is the foundation for successful investing. Through simplifying decisions, establishing goals (as well as knowing when to refer back to them), and analysing markets with an implicit acceptance, you can build the mental fortitude essential to successful investing.