In light of recent market volatility, we look at three mistakes investors commonly make that could be losing them money and suggest how to overcome them.
The last few months have proven a tough time for most investors with market volatility continuing to wreak havoc in investment portfolios. In this article we examine three investing mindset errors that could be impacting long-term returns and provide suggestions on how to overcome them.
Loss aversion bias
It’s not exactly a revelation to learn that people don’t like to lose their money. But if you suffer from loss aversion bias, you’ll do anything to avoid losses – even if it means missing out on good gains. This is because the emotional consequences of loss are too painful for those with loss aversion bias to bear.
In the investing world, this can manifest as holding on to an investment that’s losing value for too long (in the hope that it’ll recover). Or you might put your money into an unnecessarily low-risk, low-returning investment when you could be earning a greater return by taking a bit more risk.
It’s not wrong to do this (and everyone’s financial goals are different), but it could mean that you’re unwittingly missing out on returns because of your fear of loss.
One way to avoid being unduly influenced by this bias is to implement a strict stop-loss strategy, whereby you sell your investment if its value falls by a certain amount. This could help you cut your losses at an appropriate point rather than hanging onto declining assets for longer than you need to.
While we don’t want to encourage reckless risk-taking, the reasons for your risk aversion should make good financial sense and fit in with your financial goals. Remember to speak with your financial adviser before deciding what’s right for you.
As its name suggests, the bandwagon effect is about herd mentality and following the crowd rather than undertaking your own objective research into a particular investment.
Remember the dotcom bubble of the late 1990s? The advent of the internet created much hype among investors desperate for a piece of what promised to be a very profitable pie.
As more and more people jumped on the bandwagon, share prices became dramatically overvalued (i.e. implied a company was worth more than it really was).
When investors began to realise this, panic selling ensued amongst the herd. Trillions of dollars of investment capital was lost and many tech companies went under.
To avoid the ‘bandwagon effect’ try to avoid getting caught up in what the crowd’s doing and make your investments based on sound and impartial research.
In fact, if you see the crowd congregating, it can sometimes be a good idea to look in the opposite direction to see what opportunities the herd may have overlooked.
This is called contrarian investing, which as the name suggests, involves investing contrary to the crowd.
Again, it’s a good idea to speak with your financial adviser to determine the right investment path to meet your individual financial goals.
Do you overestimate the probability of good events and underestimate the probability of a negative event? If so, you might also be falling prey to optimism bias, whereby you overestimate the likelihood of success compared to the likelihood of failure.
It’s easy to see how this can cloud your judgment in the investment world. Because you believe the chances of an investment doing well are far greater than the chances it will do poorly, you might ignore key warning signs.
You might also miss potential pitfalls because you’re being overly optimistic about its prospects.
A good approach to address this bias is to think through some of the negative outcomes that could result. In other words, what are some of the factors that could make this a poor investment?
By consciously considering the other side of the coin, you are more likely to make a realistic, rather than an emotional, decision.
Beat the bias
Investing can be a daunting process, made all the more difficult by thinking errors like the ones outlined above. Knowing what to look out for and actively trying to work against them could be the difference between a successful and a disappointing investment decision.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. This is not a recommendation to adopt to any investment strategy.
Originally published by Schroders