Even though "average" means 50th percentile by definition, 65% of Americans believe they have above average intelligence. That means at least 15% overestimate their general intelligence. Imagine how much more difficult it is for them to accurately assess their investments!
People don't make bad financial decisions because they're dumb. It's because they're human, and humans are wired to approach investment topics in suboptimal ways. Three psychological factors that hurt investors are:
- Fear of Missing Out
- Loss Aversion
- Overconfidence
1. Fear of Missing Out:
Whether it's a great party or an investment that might triple next month, you don't want to miss out on the fun. People are wired to feel anxiety and respond to their fear of missing out (FOMO) based on emotions.
When Dogecoin (DOGE -4.81%) dominated headlines in April and May 2021, it soared 1000% in 30 days. It was easy to have FOMO, as the media and friends loudly touted huge returns. However, plenty of people bought at the peak and got crushed -- they just didn't publicize it!
How to Avoid It: Think logically, not emotionally. Analyze the fundamentals of the investment to determine if it's the real deal.
Source: Getty Images
2. Loss Aversion
As Nobel Prize winner Daniel Kahneman states, "The pain of the frequent small losses exceeds the pleasure of the equally frequent small gains."
This can be problematic in two ways. One, the fear of losing can prevent you from investing at all. Two, you continue holding an investment even though it's a poor choice. While selling a losing stock can seem like admitting defeat, it's often the opposite. Your portfolio has a cut, and you can stop the bleeding.
In late 2004, Blockbuster shares were down 50% off their peak, despite earning the same $5.9 billion revenue as the year prior. (Netflix was renting DVDs, but hadn't introduced streaming yet.) It was easy to rationalize holding Blockbuster. It's half price! Revenue has barely fallen! Hundreds of stores are open! Whatever the justification, many investors fell victim to Loss Aversion and rode the stock all the way down.
How to Avoid It: Have a plan. If you watch an NFL team consistently do poorly, are they suddenly going to be a Super Bowl contender? Probably not. It's OK to be wrong sometimes.
3. Overconfidence
People are often confident at the wrong times. In July 2007, just three months before the Great Recession, consumer confidence was at a five-year high (and has never returned to 2007 levels). This wasn't just a few people brash about their confidence in the economy -- it was consumers as a whole! To see if it applies specifically to you, try taking this confidence calibration test
Even if your investment rationale is solid, that doesn't mean it will work. As economist John Maynard Keynes famously said, "The stock market can remain irrational longer than you can remain solvent."
How to Avoid It: Stay humble, and don't put all your eggs in one basket.
As an investor, you want to position yourself for success. That means finding great long-term investments and holding them for five-plus years, rather than focusing on what's happening this week. It also means admitting a mistake, cutting your losses, and moving on to a better option. By understanding FOMO, Loss Aversion, and Overconfidence, you can clear these hurdles and better grow your portfolio.
