Understanding the Emotional Pitfalls of Investing

By Craig Popp, CFA, Peter Kolar, CFA, and Steve Latham
Courtesy of RBC Wealth Management Global Wealth Services

The most powerful tool available to you as an investor is your mind. Yet all too often, our brains get in the way of rational investment decisions.

Why? Raw emotion frequently triggers a wide range of human behaviors, including how we invest. Plus, cognitive abilities that help humans survive in the real world — like recognizing patterns or focusing attention — can lead to behaviors with negative consequences in the financial world.

Behavioral finance theory offers insights into financial decision making. And after decades in academia, it is moving into the mainstream.

A key to understanding behavioral finance is knowing that it defies certain accepted beliefs about investing. It operates on the premise that people neither act rationally nor consider all available information in decision making. It also does not assume markets are efficient.

A practical example can be found in a famous quote from legendary investor Warren Buffett:“Be fearful when others are greedy and be greedy when others are fearful.”

In theory such insight should help inform sound investment decisions. But in practice, it is easier said than done, because investors suffer from many behavioral finance biases.

The good news is: understanding these biases will without question make you a better investor. Here is a brief overview of some to watch out for.

Overconfidence stems from the fact that people are not aware of what they do not know and tend to be overconfident when making decisions involving uncertain outcomes. A side effect of overconfidence is hindsight bias, whereby individuals view past events as predictable and reasonable to expect. Individuals also tend to recall their own predictions as being more accurate than they were.

Overconfident investors may also suffer from illusion of control — the belief they can control or influence outcomes when, in fact, they cannot. Said differently, people tend to mischaracterize future events as being determined by one’s skill rather than chance.

The outcome is often assuming risk that is actually beyond one’s comfort level. It can lead to non-diversified portfolios, excessive trading and subpar returns. Do-it-yourself investors typically will overstate their actual past performance.

Anchoring and adjustment relate to how individuals estimate probabilities. They tend to anchor to an original estimate (or purchase price) and have difficulty adjusting to new information when it is presented. This leads to loss aversion, which causes investors to favor avoiding losses over achieving gains.

Selling a losing investment in December for tax purposes is an example. What would have been considered a loss in November is now justified as a tax deduction. Investors who suffer from this bias also tend to hold losers too long and sell winners too early.

Regret aversion occurs when investors avoid making a decision when they perceive that decision may turn out poorly. Think back to 2009 when the S&P 500 index was trading at a level not seen since 1996. Many were scared to buy equities because they were afraid the market would continue to fall. A common outcome of regret aversion is herd mentality, in which investment decisions are influenced by peers or trends — the classic “safety in numbers” theory.

Framing is when individuals adopt different outlooks based on how a question is framed. Information is processed based on the context in which it is viewed. For example, in a study by Benartzi and Thaler, investors allocated more to stocks than bonds when they saw an impressive history of long-term stock returns relative to bonds. When presented with the short-term volatility of stock returns relative to bonds, investors allocated more to bonds. 

Narrow framing occurs when investors evaluate each portfolio holding in isolation rather than in the context of the entire portfolio. Narrow framing is the enemy of diversification. The performance of the U.S. stock market versus that of international markets in 2014 serves as a recent example. The drastic outperformance of U.S. markets has caused many investors to forget about the diversification benefits of owning non-U.S. stocks.

Avoiding these common biases is difficult. Working with your financial advisor to address them is an appropriate first step.

To help take emotions out of investing, he or she can help you develop an investment philosophy and process focused on your long-term goals. Through repeated use of the process — especially during periods of market volatility — your investment strategies may be tested and improved.

Finally, broad frames can be applied when discussing performance. Focusing on long-term portfolio-level performance and achieving specific goals may also help you avoid the pitfalls of emotional investing.

To discuss behavioral finance biases and ways to help mitigate them, contact your RBC Wealth Management financial advisor or use the advisor locator tool to find an advisor near you.

Important disclosure information about Royal Bank of Canada (RBC) and RBC Capital Markets, LLC