No matter how smart or well educated you are, and no matter how successful professionally, when it comes to investing you still might not make the best decisions.
That’s because you’re human, which means you’re hardwired to respond in certain ways that serve you well in many parts of your life, but tend to work against you when it comes to making smart investment decisions, according to psychologist Daniel Crosby, author of “The Behavioral Investor.”
“Not only is high intelligence not an insulation [against bad financial decisions], it might be a red flag,” Crosby said.
But here’s the thing: If you’re aware of your mediocrity when it comes to the markets, it can actually help you be a better investor.
Based on decades of leading behavioral research, Crosby said investors easily fall prey to four inherent biases. But when you’re mindful of them you can take steps to either mute their effect, or harness them to your financial advantage.
1. Ego bias
Everyone has an ego. It protects us in many ways, in part by creating a sense of confidence – and often overconfidence – in our own abilities and judgments.
“Ego gets us out of bed in the morning,” Crosby said.
Those who become very sure of themselves are more likely to be resilient and find professional success. “People who are overconfident are often happier and more likely to be successful business people and politicians. And [a strong] ego can buffer us against setbacks, disappointment and loss,” he said.
But when it comes to investing, too much self-confidence can cost you real money.
For example, Crosby said, most of us would rather find information that confirms what we already believe rather than seek out information that challenges our beliefs. He cited research showing that even when presented with facts that directly contradict what we believe, thanks to our ego, we may become even more entrenched in those faulty beliefs.
One way this might play out when you’re investing is that you may feel sure that a given company or new asset class – like crypto – will win the future. So you throw a disproportionately large amount of money at your can’t-lose-idea.
But research suggests cherry-picking what you believe to be future winners in place of investing in the broader market may hurt your returns in the long run. Crosby cited statistics showing how active stock fund management performed less well than passive indexing more than 80% of the time over five- and 10-year periods. And that’s before accounting for the higher fees an investor pays for actively managed funds.
2. Conservatism bias
Investing always involves risk. But people’s desire to stick with the familiar or take the adage “invest in what you know” too far can actually increase that risk.
Crosby used an example of someone who works in the tech industry, buys a home in a tech hub like San Francisco and invests primarily in tech stocks. The upshot: Her financial prospects will be disproportionately dependent on the health of the tech sector because she is devoting most of her time and money to it through her job, her property and her portfolio. When the tech sector takes a hit, she could get clobbered financially.
Another way investors often default to the familiar is to primarily invest in US stocks in the belief that non-US stocks are too risky.
3. Attention bias
Humans tend to pay disproportionate attention to bad news or high-drama, low-probability events (e.g., shark attacks or planes flying into buildings). Both can distort our perception of risk.
What’s more, information overload – whether from data or research or news – can lead to misguided decisions because too much information makes it hard to see the forest for the trees, Crosby noted.
4. Emotion bias
Our emotions and intuition can protect us in some difficult situations, or they can help guide us. For instance,you might finally pick a good partner after years of dating others who were never quite right for you.
But they can also cause us to act rashly in the moment, and override what we normally know we should do.
Think donuts, Crosby suggested. You may have gotten all the nutritional counseling in the world, but under peak stress you will invariably reach for the powdered donuts, not the asparagus.
How emotion plays out in the markets can be costly. If your fear is activated, you can panic and sell at the wrong time. Or if you’re elated, your optimism may distort your sense of how much risk you’re really taking on with an investment.
Strategies to beat back our biases
Investors can seek to override their inherent biases in many ways, Crosby said. Among his suggested strategies:
Tune out the noise. Don’t check your investment accounts daily. Don’t fixate on every gyration in the market. Don’t drown yourself in metrics. And don’t let negative events disproportionately drive your investment decisions.
Have humility. You can’t predict the future. And you will never have perfect information to make a sure bet on a single stock or sector.
Diversify your holdings. Crosby put it this way in his book: “Diversification is … the embodiment of managing ego risk. [It]’s a concrete nod to the luck and uncertainty inherent in money management and an admission that the future is unknowable.”
For example, to counter so-called home bias in your investments, Crosby suggested you shouldn’t invest much more in domestic stocks than their percentage of the world market. Depending on how they’re measured, US equities represent anywhere from 45% to 60% of the global equity market. But average US investors typically have a much larger share of their equity holdings in US companies, and very little in foreign stocks.
Put a system in place. Automating your savings and investing across a diverse portfolio regardless of market conditions often works well. The same goes for automatically putting away a certain amount of savings for near-term goals and emergencies.
“It’s less about the perfect process and more about having a process,” Crosby said.
One example is the idea of “set it and forget it” with retirement savings. Employees who choose the option in their 401(k) plan to automatically increase their savings whenever they get a raise do better than if they have to make decisions every month about how much to save.
Use emotions to your financial advantage: One study Crosby cited showed that low-income parents were likely to save twice as much money when they had an envelope earmarked for savings that has a picture of their children on it.
Realize no investment is perfect. Many people get their exposure to the stock market through their 401(k)s, specifically through target date funds that their employers offer as the default investment.
While target date funds have their critics, Crosby said, “Every investment is imperfect. … And [target date funds] are so much better for the average person than what the average person is doing.”