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Emotions can mess up an investment plan. Beware of 6 irrational ways to make decisions

(USA TODAY) – It’s hard to say if now is one of those calms before the storm. But at the least, it’s a period of relative calm after the coronavirus-induced stock market plunge in February and March and the robust rally that followed.

And that makes it a decent time to assess how you might have messed up your investments by selling hastily or taking other irrational actions.

“We’ve had a severe recent drop … that makes this stuff real important,” said Steve Wendel, head of the behavioral-science team at Morningstar that studies how emotions can derail investors.

If you work with a financial adviser, that person should be helping to guide your actions. Wendell spoke primarily to advisers during an online meeting this week hosted by Morningstar, but do-it-yourself investors also can learn from the discussion.

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Behavioral finance is a field that examines how people make decisions, with special attention to irrational ones. Researchers have identified more than 100 biases or tendencies that lead to poor decisions, said Samantha Lamas, a behavioral researcher at Morningstar. 

Here are six prominent ones gleaned from their online discussion and from a research report focused on behaviors and volatility that Morningstar compiled in the wake of the market’s selloff:

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1. Focusing on recent events

One potentially problematic tendency or bias is when people place unwarranted importance or attention on what happened today or over the last few days when the recent trend might not be all that critical or persistent.

When the stock market fell sharply over a four-week span in late February and early March, recency bias convinced some people that it would continue to falter. Those who reacted by selling paid a price, as the market just as quickly began to recover.

2. Blindly following along

Herding behavior is the tendency to look to what other people are doing, especially during times of stress. We do this all the time in normal activity, such as reading online restaurant reviews. There’s something comforting in sticking with the crowd, as this was important to human survival many times in the past.

But during periods of high stock-market volatility, it can be a bad move as the crowd might get it wrong. During such times, plenty of people overreact or make poor decisions for various reasons, so following the crowd can be a mistake.

3. Taking unneeded actions

Action bias is the perceived need to do something during stressful times, as when stock prices are falling. During broad market downturns, the action that often seems most appealing is selling. But if you do sell, you might lock in a poor price or trigger taxable gains that otherwise could have been delayed much longer.

“The urge to take dramatic action can trick us in cases where the statistically correct choice is thoughtful inaction,” Morningstar said in its report. Rather, doing nothing often is the smart move, especially if you have many years for prices to recover.

4. Trading through overconfidence

Overconfidence bias is the tendency to view ourselves as above average, whether it’s as golfers, gardeners, dog owners or whatever. In one study cited by Morningstar, 90% of motorists considered themselves above-average drivers.

Overconfidence bias leads us to believe that we’re better than most. As a result, we might make reckless investment decisions, although this bias isn’t so obvious during market downdrafts, when your confidence could be deflating.

Certain groups are more susceptible to this bias than others. When investing, “Men tend to be more overconfident and trade more than women, and their net returns are lower because of that,” Lamas said.

5. Seeking out validation

Confirmation bias is the tendency to seek out and interpret information that supports one opinion or recent action, like exiting the market. We want some assurance that we did the right thing.

“Our minds will automatically pay more attention to information that supports our current beliefs,” said Morningstar in its report. But sometimes paying too much attention to agreeable views can mislead us by not providing a more balanced perspective. The information we seek might be wrong.

It’s thus a good exercise to contemplate the opposite viewpoint. If you’re selling a stock, for example, consider the many reasons why someone on the other side of the trade might be buying it.

6. Avoiding the pain of losses

Loss aversion is the tendency to be upset by losses to a greater degree than we derive enjoyment from gains. It’s a tendency that can make us too fearful and otherwise cloud our judgment when the market is moving against us.

“A 10% portfolio loss feels a lot worse than a 10% gain for many investors because we are loss-averse,” said Morningstar in its report. Any given loss “generally feels twice as bad as gaining the same amount.”

Some potential solutions

So these are some of the psychological tendencies or biases that can work against investors. How can you deal with them?

One recommendation is simply to be aware of these tendencies. Recognizing a problem can help you overcome it.

Then there’s the importance of understanding risk tolerance. Advisers routinely ask clients about how much downside movement they can accept, but many people don’t know until the going gets tough. It’s smart to periodically review what normal turbulence looks like, Morningstar suggests, and remember that our personal risk appetite might change over time, often to a more conservative mode.

In the same vein, set realistic expectations. The wild ride earlier this year — one of the sharpest and shortest bear markets on record — was highly unusual. But investors should remember that market downdrafts are part of the cycle and occur every few years on average. 

Also, beware of becoming a victim of information overload. Tracking the market too often can put anyone on edge, especially during tumultuous periods.

The tendency to be influenced by too-frequent information is called myopic loss aversion.

“It’s a combination of loss aversion — our heightened sensitivity to losses rather than to gains — and a narrow focus on the ‘now,’ Morningstar said.

The more frequently you check your portfolio, the more often you might be tempted to make a bad decision. Limit your portfolio updates to once a day, once a week or even less.

Among other tips, you might even write a letter to your future self. This letter should explain what you really care about, what matters with your investments and why you’re going through all this trouble in the first place, Morningstar said. The next time there’s heightened market turmoil, pull out the letter and review it.

Finally, you can set up barriers to slow down your tendency to take impulsive actions that you might regret later. Among the suggestions: View volatility as a time to rebalance your investments, heed a self-imposed cool-down period of perhaps three days and analyze the tax implications before every transaction. Not wanting to incur taxable gains prematurely can be a powerful incentive to slow down, Morningstar said.

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