The Rational vs. Irrational Investor

On occasion, we all make questionable decisions and reach incorrect assumptions. Often, this is due to cognitive biases—built-in tendencies that we all share.

Many social psychologists believe cognitive biases help us process information more efficiently. But in some situations, these biases can lead us to make serious mistakes. When it comes to investing, it’s important to recognize (and hopefully avoid) the negative impact of cognitive biases on your financial decisions. I highlight four of these biases below and point out some rational responses to counteract them.

Irrational Bias 1: Overconfidence

Investors who see their portfolios rising for extended periods can easily forget previous down markets. This overconfidence can lead them to make risky decisions.

Research shows that men are particularly vulnerable to this bias. According to Brad M. Barber, Professor of Finance at the UC Davis Graduate School of Management, “Men tend to be more overconfident than women, and overconfident investors tend to think they know more than they actually do.”

Rational Response:

In these situations, revisiting your comfort level with risk could help you get your confidence in check. A quick call or email to your financial professional could also give you added insights.

Irrational Bias 2: Anchoring

The concept of anchoring revolves around people’s tendency to cling to a single piece of information during the decision-making process. This is often the first information they encounter. Once the “anchor” is set, other judgments are made based on that anchor.

Consider an investor who first encounters a mutual fund that is priced at $22 a share. If the price of that fund later drops to $18.50, that person may think he or she has found a “bargain.” In reality, however, the original $22 price may have been overvalued.

Rational Response:

Evaluate an investment based on a variety of fundamental metrics over time. Focus on the overall asset allocation plan and less on the day-by-day prices of individual investment options.

Irrational Bias 3: Loss Aversion

As Nobel-Prize winner Daniel Kahneman discovered, a loss generates 2.25 times more pain than the pleasure generated by an equivalent gain. A loss of $1,000, for instance, could only be offset emotionally by a gain of at least $2,250. This level of emotional “pain” could easily lead an investor to sell during periods of volatility—just to make the pain stop.

Rational Response:

Focus on your goals for the long term to help avoid this pitfall.

Irrational Bias 4: Mental Accounting

Our brains have a natural tendency to organize information. When it comes to money, we tend to view some assets as being different from others based on their source or intended use.

This can be helpful for investors who set aside a specific amount of money each month for retirement or another goal. That money is off the table, in a sense, because it’s in their mental “savings” box.

In other situations, however, this can work against investors. A modest but unexpected inheritance is a good example.

Because those inherited assets aren’t part of the investor’s current financial plan, he or she may feel like it’s “fun money,” even though investing those assets could go a long way toward helping the investor achieve an important financial goal.

Rational Response:

Working with a financial professional on a “save some/spend some” plan to help overcome this bias.

The payoff of rational thinking

Emotional investing can be costly. Taking a rational approach, on the other hand, can help you focus on the essential elements of successful investing—a diversified approach and a focus on the long term.

 

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Asset allocation and diversification do not ensure a profit or protect against a loss.

Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc.

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