Key Behavioral Traps and How to Avoid Them

Psychological factors--such as the tendency to feel particularly risk-averse following a bear market or a proclivity to follow the crowd--can play enormous roles in our investment outcomes, and often they are not a positive ones. Morningstar.com focused on behavioral-finance factors in our "Inside the Investor's Mind" special report this past week, in which Morningstar analysts and expert theorists offered insights on helping investors identify, correct, and even profit from the most common behavioral pitfalls.

To help kick things off, I asked Morningstar.com Discuss forum participants to do a little soul-searching. Had psychological factors, rather than a calculated assessment of investment considerations, driven their financial decisions in the past? I also asked whether they had any successful methods for combating those behavioral traps.

To read the complete thread or add your own experience with the intersection between psychological factors and investment decision-making, click here.

'Fear Runs My Life as an Investor'
Of any behavioral trap, excessive loss aversion received the most mentions among Morningstar.com readers. This is probably not surprising given that we've experienced two major bear markets since 2000.

A classic example of loss aversion is being unwilling to sell a loser, even if you know it's flawed from an investment standpoint. Darwinian copped to that pitfall, writing, "My biggest problem has been loss aversion. I have sometimes made investment changes that immediately turned out bad, and it has been very difficult to convince myself to cut my losses."

This issue has tripped up FidlStix, too. "My main long-term failure in investing is a tendency to hold on to a stock I like too long, even when it should be clear it's going nowhere but down. For example, Dynamic Materials (BOOM) a few years ago. Having something with the ticker BOOM in my Roth was just too cool," he quipped.

Excessive risk aversion is a related behavioral trap, particularly for people with long time horizons. Danielle shared, "My decision-making was definitely impeded when I had to retire suddenly at the peak of my career due to illness," this poster wrote. "Despite having a well-thought-out safety net in place, I panicked and became overly conservative in my investments. My banker noticed what was happening and literally staged an intervention with a financial advisor."

A shortening proximity to retirement has led Zorkl55, a psychologist, to become more risk-averse as the years go by. "The older I get, and I am now 65, the more fear runs my life as an investor. If I have only the amount of equities necessary to let me sleep well, I risk running out of money late in life. In most areas of my life I am a bold contrarian. In matters of money, these days, I am working to honor my emotions without letting them run wild in what I find to be a remarkably challenging set of investment conditions. For example, in 2008-2009, I told my adult children that stocks represented an unprecedented buying opportunity, maybe the chance of their lifetime. What did I do? I watched them buy, while I waited another 18 months to jump in . . ."

'I Learned Hard Lessons Along the Way'
Recency bias, which can encourage investors to chase the so-called hot dot, tripped up HerbertH in the past--but no more. This poster observed, "Just as I started to see bigger-than-expected gains coming from my stock holdings, I would want to buy more of it. This all continued till my portfolio sank by a significant percentage because I had all my eggs in one basket. Now I'm a more cautious investor. I learned hard lessons along the way."

Moving your investments with the pack--a behavior that finance experts call "herding"--is a key pitfall to avoid. Scrooge opined, "Whenever everyone believes the same message and acts the same it is wrong."

Davemck21 finds himself disproportionately plugged into what's going on with the adventurous segment of his portfolio, even if it's not a big portion of his overall portfolio. "I have noticed while managing my own little hedge fund I find myself looking at it daily and obsessing with the ups and downs of the market--not healthy! I also find my performance is inversely proportional to the amount of time I spend analyzing it. Much like most highly paid fund managers I have learned that I probably will not beat the S&P 500 long term."

Juris2's example illustrates that behavioral pitfalls may ebb and flow, depending on the investor's own experience as well as fluctuations in the market. Reflecting on his life cycle as an investor, this poster wrote, "My major mistakes have included being: a) too passive in managing my accounts from 1975-97 (I literally set and forgot my 403(b) investment preferences for 23 years; on balance, though, this approach was better than what came next); b) I started to pay attention to my investments and got too ambitious in tracking the dot-com explosion from 1997-2000; and c) too exposed [not risk-averse enough!] when the 2008-09 crash came. Since then, I've done very well with a much more balanced approach--that is, for the past . . . four years. But, of course, this has been a four-year bull market."

'The Less I Mess Around With Our Portfolio, the Better It Does'
Posters also shared helpful tips for countering their own worst behavioral instincts.

Echoing the advice of many behavioral-finance experts, Danielle suggested that a good investment advisor--or even an investment buddy--can help talk you out of your own bad ideas. "I still benefit from sitting down with a financial advisor every few years just to keep from getting too wound up," she wrote. "Someone who handles their own (and their family's) investments does need to get some outside advice when facing unexpected major life changes. One's view is always prone to confirmation bias [the tendency to selectively seek out evidence that corroborates what you believe]. If your view is distorted, your investments will be, as well."

Darwinian aims to play the devil's advocate role for himself. Before making a change to his portfolio, he thinks, "If I read in Morningstar that someone was about to do this, would I try to dissuade him? Often, this leads me to recognize problems that I otherwise would have missed, due to confirmation bias."

For August, a financial advisor's guidance was central to getting him to purchasing an annuity that, while painful to buy, has provided much peace of mind during turbulent market environments. "I retired in 2007 at age 65, following the advice of a financial counselor at the end of 2007 I bought a fixed annuity (TIAA-CREF) although it was emotionally somewhat difficult to part with about 40% of my retirement savings. With interest rates higher at the time I get about 7.4% a year and have also the feature of payments for 20 years in case I die early. The annuity payments and Social Security cover my very basic expenses. All other funds are in stock mutual funds. As a result of the annuity I was behaviorally able to tolerate the fiscal turmoil of the past few years and have seen my stock mutual funds recover and do very well now withdrawing mostly only the RMDs."

For Darwinian, a big believer in the benefits of diversification, relying on what the numbers say is a good way to stave off behaviorally induced missteps. "As soon as I learned about asset allocation, I immediately saw that this was the ideal way to avoid the extremes of greed and panic, so I now allow my allocation spreadsheet to dictate all my rebalancing decisions. I diligently employ historical data, to overcome my recency bias. I deliberately counteract overconfidence; whenever I think something is certain to happen (or not), I adjust my expectations down to 80%."

Mechanistically rebalancing has also helped Galeno stay out of trouble. This poster wrote, "I rebalance mechanically forcing a buy-low/sell-high situation."

Chief K uses a self-described "three-step program" to keep himself from making rash changes to his investment plan. "1) Make a decision to sell (and also decide what to buy). 2) Establish a 'cooling-off period, of a month or two to allow plenty of time for reflection. 3) Then either abandon the idea (I've done that once) or go ahead." The Chief concluded, "I don't think asset allocation/retirement planning requires quick thinking and lighting fast reflexes. 'Don't do something; just sit there' is often great advice."

GregLee believes that limiting investment activity has kept him out of trouble, too. "For one thing, I don't trade securities, so any impulse I might have to chase performance is not given a chance to express itself."

Galeno concurred that when it comes to portfolio oversight, less is definitely more. "The less I mess around with our portfolio the better it does," this poster concluded.

In BMWLover's view, and in the view of many respondents, experience is the best way to avoid letting your emotions drive your decision-making. "Of course emotions have impeded my investment decision making, but I think more so over my early years rather than more recently. I've learned that I will not get rich quick, that I cannot time the market, that I will have winners and losers, that I can't be invested in every stock that soars for the sky, and that if I am patient my stock selections usually do rather well in comparison to the market in general."

'It Takes a Lot of Discipline and Acute Awareness'
Although respondents' prescriptions for combating behavioral biases varied, many posters agreed on the importance of paying attention to the intersection of psychology and financial decision-making.

Pkcrafter opined, "I believe behavioral errors are the number one cause of underperformance, and we are all subject to them. Investors can't avoid behavioral mistakes if they are not familiar with them, and even then they may not recognize them. It takes a lot of discipline and acute awareness to avoid pitfalls along the investing road."

Zorkl55 concurred about the real-world difficulty of combating behavioral tendencies. "It is remarkable that my head can know the literature on behavioral finance, while my emotions can at times run my investments."

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