Do you remember Bitcoin? Probably, but do you spend as much time thinking about it as you did in early 2018? Most likely not, and if that’s the case maybe now is a good time to reflect on the lessons learned from the Bitcoin frenzy. Whether it was Bitcoin or some other great investment idea you obsessed over, its biggest value may have ended up being the lessons it taught you in behavioral finance.
If everything else about your investment thesis stays the same when the price of an asset declines, you should become more excited about the prospects of purchasing it. A good investment plan contains an exit strategy, and this shouldn't change when a new investment contains even more upside potential.
However, when an asset’s performance stops replicating prior success, it’s not uncommon that it suddenly feels inappropriate for your risk tolerance. If your appetite drops off significantly solely because an investment pulls back, chances are your initial decision may have been influenced by some very common behavior biases. Be aware of the following investing biases to ensure you're not falling for current investing trends.
When an investment was hitting its historical highs, it’s possible this moment also happened to coincide perfectly with when you were developing a positive outlook for its investment prospects. If that was your reason for being a purchaser, you likely made a well-disciplined investment decision. However, if your decision was based entirely on the expectation that it would continue its recent performance, you were likely a victim to trend following. There’s a reason why the first disclaimer on any investment document you receive is “past performance is not a guarantee of future results.”
How do you know if you succumbed to trend chasing? Looking back at your decision-making process will provide some key clues. How did you come about the investment and did it seemingly fall from the sky? How long did you think about the investment and what research did you do before making the decision? What were some alternatives you considered? All these questions may provide shocking answers that illuminate where you failed to think independently. (For related reading, see: Behavioral Finance: Key Concepts – Herd Behavior.)
An extremely common cause of trend-following behavior is believing that somehow the prior results were perfectly predictable. You think you should have anticipated these results at the time and participated in the stellar performance up to this point. You remember reading an article about an investment a few years ago but never bought any of it. Certainly, you won’t be that foolish again, right?
It’s important to always consider the source of where you first learn about an investment. Is it a reputable one that you consider to be included in your investment process? If not, then you probably can’t consider what you read or hear to be actionable. Vet the idea through your other sources first. This is what due diligence is all about.
Maybe you weren’t concerned with achieving the performance, but rather you were afraid of regretting being the only one who didn’t participate because it seemed like everyone you knew was making this investment. You couldn’t watch the news at the gym or make small talk in the elevator without touching on the subject. Just imagine how awful the social interactions would be if you were left out. We all know there are plenty of reasons for social events to be awkward to begin with, but your investment decisions should never be one of them.
Sunk Cost Fallacy
Do you know people that still hold their Bitcoins? Do they still do this because of their continued bullish outlook or because they already have a big loss in the position? If it’s the latter, this behavior is not one that leads to making good investment decisions going forward. Smart investing involves having a steadfast procedure for decision making and regularly revisiting it.
As mentioned earlier, a strong investment strategy includes an exit strategy. There are important questions you should consider before the initial investment. If the price goes up to some value, am I going to sell? If it goes down to another am I going to rebalance back up to my original investment amount? What are the key factors I will reassess at any of these points? Having an answer to these will go a long way toward separating yourself from the emotion associated with whatever those dollar amounts may be. (For related reading, see: Exit Strategies: A Key Look.)
Learn from Your Mistakes
Investment decisions based on sound processes are more replicable in the future. It’s very unlikely that getting lucky on one investment idea will define your financial success. Having a disciplined and defined approach to your decision making allows you to weather the inevitable turbulence of financial markets and achieve more predictable outcomes. As with most things in life, preparation is a key to success.
Virtually no long-term investor is going to make it a lifetime without their own trend-following experience. Some will learn such investments are well outside their risk tolerance, others may learn they will have a profitable future by weathering highly volatile assets. But what is most important is all investors are also learners. There is almost nothing more detrimental to your overall financial well-being than consistently succumbing to behavioral traps.
(For related reading, see: 4 Behavioral Biases and How to Avoid Them.)