The real cost of impulse investing

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It seems to happen every fall. The stock market is doing well, hitting new highs every week or so. And then, in September or October, something scares the markets.

Investors who have ignored economic warning signs all year round suddenly start paying attention. Sometimes when the S&P 500 drops around 5%, they decide to sell quickly, ignoring the double-digit gains it has posted so far.

They rely on CNBC to guide their next move. They spend every waking minute wondering whether to hang on or get out of it.

Millions of people invest this way, on impulse. They worry whenever there is a sign of turbulence in the market and give in to their fears, then burn themselves.

We have all seen this movie and know how it ends. And who benefits the most? The huge institutional traders on Wall Street.

They profit by capitalizing on the impulsive behavior of Main Street investors. Motivated by the double fear “I can’t afford to lose” and “I don’t want to lose”, these investors regularly buy high and sell low.

And Wall Street profits by selling high and buying low. Every time, year after year.

The inevitable results of these David vs. Goliath business interactions are so predictable that Wall Street has a euphemism for it: exploiting market inefficiencies. Big traders can predict with pinpoint accuracy when regular investors will give in to their fears or greed.

Their analysts have access to the information they need to buy or sell stocks at the best price long before that same information reaches regular investors.

Here’s how to understand and avoid self-destructive behaviors.

Self-destructive behavior

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Emotions are the enemy of investing. When you are in doubt, you are more likely to adopt certain thought patterns or superstitions that lead to bad decisions. When you’re emotionally biased, you’re less willing to listen to opinions that might keep you from going down with the ship.

Psychologists have developed a whole area of ​​study to identify these types of self-defeating thought processes: behavioral finance.

Numerous studies have shown that anxious investors often see and react to trading patterns that don’t really exist. They develop prejudices which are not easily shaken. And they don’t see the financial forest for the trees.

While hundreds of these behaviors have been researched and listed, there are a few that even the most experienced investors will recognize as applying to themselves at one point or another.

Loss aversion

Worried man raises his hands in a stop or stop motion
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Research has shown that investors are much more upset when their portfolio has lost 5% in value than they are happy when it increases by 10%.

They are more likely to hold a falling stock in the hope that it will rebound. And they’re much more likely to sell a stock that has risen in price long before it peaks.

Framing

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Even though we consciously understand that a diversified portfolio helps offset the fall in the price of one stock with the rise in the value of another, we still tend to obsess over the outsized profits or losses of individual stocks. , regardless of the low overall impact of a security on our portfolio as a whole.

Anchoring

Investor panics after stock market crash
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The way certain types of information are presented can influence our thinking. For example, when the stock market goes down 10% or more, the media has conditioned us to view it as a market correction, with all of its associated apocalyptic alarmist messages.

But that 10% is just an arbitrary numerical indicator that is no better at predicting a bear market than a 5% drop.

Availability bias

Older man scratches his head and wrinkles his nose in thought
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People who have experienced a recent major event tend to believe that a similar event will occur when certain pre-event situations have occurred.

A good example is the belief that rising rates of COVID-19 infections are likely to trigger a stock sell-off similar to the three-month bear market of 2020.

Conservatism bias

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When investors have a firm belief in a certain company that they have invested in, they tend to hold on to their faith even when the company is going through a rough patch. The fall of Enron in the early 2000s is a classic example.

Even when news of the company’s scandals came to light, too many investors believed Enron would get away with it – and ultimately lost their entire investment.

So how do you avoid financial abuses?

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It is essential to increase your financial awareness. Recognize the beliefs and fears that motivate these behaviors, and make a determined effort to think before you act.

Start by diagnosing your financial health. If you’re sure you’re on track to saving enough for retirement, your children’s college education, or other goals, you’ll be less likely to engage in behaviors that could derail your investment plan.

This can be difficult to do on your own, which is why you may want to hire the services of a Qualified and paid fiduciary financial planner.

This professional can help you overcome your fears, overcome inertia, and overcome prejudices by helping you determine exactly where you are financially today and what you may need to get back on track. And if you hire them to manage your investment portfolio, you’ll sleep easier knowing your financial future is in good hands.

Disclosure: The information you read here is always objective. However, we sometimes receive compensation for clicking on links in our stories.


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