Human behavior, particularly when it comes to investing, can be hard to predict. While traditional economic models say that humans will always act in their own best interest—and that may be true—savvy investors and their advisors know that sound investment decisions take finesse and strategy. It’s not as simple as plugging five possible stock options into a cost-benefit calculator and selecting the one with the greatest return; you have to be able to look at economic trends through a real-world lens and understand the full picture.
“Economics says that humans have stable preferences, that we evaluate costs and benefits, and then make decisions according to this very rational perspective. But what we actually see is that people often are making decisions based on emotion rather than rational thought.”
— Mariel Beasley, co-director of Common Cents Lab
Because of the thought required, investment decisions are rarely made lightly. There’s a lot of time and effort that goes into planning investment strategy—so what might cause a shrewd investor to make an irrational investment decision?
Our own innate mental shortcomings.
“In the investing space, it can be incredibly difficult because there’s a lot of uncertainty,” shares Mariel Beasley, co-director of the Common Cents Lab at Duke University. “And we know that as decisions become more complex, humans rely more and more on mental shortcuts to make decisions, rather than true rationality.”
Human emotion and the influence of outside factors—such as societal norms, loss aversion, and other psychological barriers—all impact our decision-making process, whether we want them to or not. Through her work at the lab, Beasley and her team use economics, social and cognitive psychology, and behavioral science concepts like choice architecture to explore the financial psychology of how these factors influence an investor’s decision-making.
“Economics says that humans have stable preferences, that we evaluate costs and benefits, and then make decisions according to this very rational perspective,” continues Beasley. “But what we actually see is that people often are making decisions based on emotion rather than rational thought.”
While you’re never going to completely eliminate these mental shortcuts or emotion from your decision-making process, there are things you can do to avoid irrational decision-making, mitigate blind spots, and approach your financial strategy with a healthy combination of rationality and humanity.
Take the emotion out of it
“As humans, we tend to overvalue things that we already own,” says Beasley. “Once you actually own a stock you might be less likely to sell it, even if it is a dud.” With that in mind, it’s important for investors to prepare themselves for the emotional ups and downs of investing right from the start.
One way to do that, as cheesy as it may sound, is to write a letter to yourself when you make a new investment. It doesn’t have to be anything fancy, but while you’re in a less emotional state—the market is good, you’re happy with the new investment—jot down why you decided to go this direction and give yourself some unbiased advice about how you should handle this investment if the market changes. By having it in writing, you can revisit your rationale in the future, when emotions may be running high due to market volatility.
You should also make time on a regular basis to “go through your entire portfolio and decide if, at today’s price, you would still buy the stocks you currently own,” says Beasley. “If the answer’s yes, great. Hold onto them and potentially buy more. If the answer’s no, it’s time to sell because you’re subconsciously telling yourself that the investment might go down in the future.” Again, the goal here is to look at your portfolio objectively and streamline your investments based on your long-term goals, not your current excitement or concerns.
“As humans, we tend to overvalue things that we already own. Once you actually own a stock you might be less likely to sell it, even if it is a dud.”
— Mariel Beasley, co-director of Common Cents Lab
Know your risk aversion can change
Beasley says it’s important for investors to acknowledge that they’re not always picking a portfolio that matches their true risk preference; your risk aversion may change according to the options presented to you.
“You should avoid looking at your options and thinking, ‘I know I’m not interested in the most conservative option that’s available, I’m one up from that’—or ‘I know that I would never select the most aggressive choice, I’ll go one step down,’” says Beasley.
Each investment option should be evaluated independently, because, depending on the options presented to you, your risk aversion can shift without your fully realizing it. For instance, if you’re shown a set of potential investments that includes an option far riskier than anything you’d ever consider, it makes sense that you may automatically choose a slightly less risky option. Where this gets tricky is when the “less risky” option is still a higher risk than you’re typically comfortable with.
If you simply evaluate all your options based on your perceived risk aversion—always just selecting the option one step down from the riskiest, for instance—you could end up with a portfolio that’s not actually in line with your end goals. Instead, focus on making all your investment decisions on a sliding scale. Think to yourself: “If all these other options weren’t available, would this still be my choice?”
Perform your own testing
If you’re interested in adding a different type of investment to your portfolio, one about which you’re unsure how it will play out in the long run, “pick an income stream that you feel you can do anything with—maybe half of your tax refund, for instance,” suggests Beasley. Use this dedicated money to perform your own test and see how the investment performs before incorporating it with your main portfolio. Since we tend to think about money differently depending on where it’s coming from, you’re likely to be slightly less sensitive to the investment’s performance and evaluate it more objectively.
In addition, financial literacy skills are best taught by managing money in real life—so using this dedicated income source for specialized investments can also be a great way to teach your children or family members about investing. They can learn through real-world experience, but in a limited or controlled environment. This strategy also helps prepare them for the future, especially if you plan to have them manage your investment accounts.
In the end, there’s only so much we can do about human behavior. Emotions will always be a part of how we make decisions—it’s what makes us people rather than computers. But for savvy investors, objectivity is key—and the trick is to understand your financial psychology so you can find ways to strategically work through blind spots or shortcomings as you evaluate your portfolio.
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