The psychological hardwiring that helped us survive in primitive times also make us vulnerable to dangerous errors and biases when handling our investments in both bull and bear markets. Read on to learn about the catch phrases to watch for in a bull market, and some of the mental errors and biases they could signal.
"I know investment markets are going to pull back. I will put the money to work then."
When you hear a phrase like this, the investor could be suffering from "confirmation bias." Confirmation bias is a result of our brains trying to avoid cognitive dissonance, or having two conflicting thoughts. It occurs when investors filter out relevant evidence about their investments that contradicts their beliefs. With all of the information available about the direction of investment markets and the economy, it is easy to latch on to what you want to hear and filter out information that contradicts your past judgment. In a new bull market this bias can cause investors to ignore information that the economy and the financial markets are recovering. It would mean that they were wrong about their recent decision to sell or not buy certain investments. It can cause them to "sit on the sidelines" too long while investment opportunities pass them by. It is always good to think independently when investing, but make sure that you keep your ego in check and have an alternative plan if markets do not go your way.
"I finally had a profit, so I sold that investment."
There is nothing wrong with taking profits, but keep in mind that investors are constantly fearing regret and seeking pride. This is what is called the "disposition effect." It is a result of the pain of an investment loss hurting much worse than the pleasure of a gain. Academic research has shown that investment losses hurt about two and a half times more than the positive feeling you get from an equivalent investment gain. Net of taxes, whether you have a gain or a loss in an investment says absolutely nothing about its future prospects. In a new bull market this bias causes investors to sell winners too early (seeking pride). Also, the painful regret associated with taking losses can keep investors from selling past bear market losers to buy new bull market leaders. To help yourself avoid this bias, make sure that you have a process for buying and selling investments that is disciplined, fundamentally sound and repeatable. The bragging rights associated with quick gains are great, but the future profits you may miss could have been even better.
"The market has gone up too far and too fast. We are due for a market correction"
This phrase could signal what is known as "anchoring" or "reference point." Anchoring occurs when someone assigns a number, like a 52-week high or low, to compare the price of an investment. Most academics and investment professionals would agree that the stock market is at least weak form efficient, meaning that past price movements are poor predictors of future price performance. Long-term investing using past price patterns alone can be compared to driving your car forward while using your rearview mirror as a guide.
In a new bull market, anchoring can lead to "market acrophobia," where investors believe that because investment markets went up quickly from their lows they are due for a large correction. It can also give investors a false sense of value and lead to excessive risk taking in the initial stages of a bull market. Because investors have a tendency to believe that an investment is "cheap" or not as risky if it has already fallen a lot in price. Keep in mind that prices and investment fundamentals are constantly changing. Whether or not an investment has risen or fallen in the past tells you very little about its current fundamental valuation and long-term investment prospects today. (To learn more about the different levels of market efficiency and what they mean see Working Through The Efficient Market Hypothesis.)
"I will never buy stocks again"
This phrase could signal the "snake bite effect." Snake bite effect occurs when investors take large losses in a certain asset class, like stocks, and become more risk adverse. The emotional toll from their past bear market losses can be so great that they feel the need to reduce exposure to the asset class or abandon it all together. It is important to think about your investment objectives, risk tolerance, and capital market expectations, and invest accordingly. In a new bull market this bias can lead to an under-diversified portfolio, or a portfolio that does not match the investor's objectives. It may stink, but if it meets your long- term investment goals sometimes you just have to hold your nose and buy.
Famed investor Benjamin Graham once said, "Individuals who cannot master their emotions are ill-suited to profit from the investment process." Mr. Graham knew that having control over your emotions when investing can mean the difference between success and failure.
It is important to understand that, because we are all humans and not computers; we will not always make perfectly rational and timely investment decisions. Knowing some of the catch phrases to look for and the mental errors and biases that they may signal can help you make more rational investment decisions and suppress your inner "Captain Caveman" when investing in a new bull market. (To continue learning about investor behavior read Taking A Chance On Behavioral Finance and Understanding Investor Behavior.)