Fear is one of our most primal feelings. When harnessed correctly, internal fear can be an incredibly powerful motivator. For instance, the fear of failure drives us to do our best every day. However, if fear is not harnessed correctly or if the fear is too powerful, we become paralyzed. Paralysis by fear inhibits our mental processes and can lead to rash and often irrational decisions. This is especially problematic when fear creeps into your investment decisions.
This is the second article (read the first here) in a series of behavioral traps that top investors recognize and avoid. The traps I’ll discuss today center around fear and how it can hinder investors.
1. Status-quo bias. Humans are wary of change, and that leads us to make choices that conspire to maintain the status quo. It’s also called the “system justification bias” (e.g. Jost et al., 2004) a rather fancy term for sticking to your comfort zone and missing opportunities outside it because of fear of the unknown.Think of all those hapless investors clipping coupons from bonds during the high interest days of the late 70s and early 80s, and you’ve got a pretty good example of status quo bias.
2. Negativity bias. It’s been theorized that we perceive negative news to be more important than positive news. That’s why you never see the headline: Jetliner Lands Successfully. This leads humans to dwell on bad news, or to overestimate the probability of a negative event rather than embrace the possibility of a positive outcome (e.g. Michel-Kerjan&Slovic, 2010). This bias leads to probability neglect (e.g. Sunstein, 2002) and affects our ability to properly assess risk, whether it’s overstating or understating unlikely events. The result is that those who suffer from this tend take excessive preventative action. If you know an investor who sells on corrections – often defined at 10% to 20% market swoons – then you know an investor with a bad case of negativity bias.
3. FOMO effect. This is the phenomenon of people doing something primarily because others are doing it and you don’t want to miss out. The first dotcom bubble was a classic example of this, and perhaps a few years from now Bitcoin will be perceived in the same way. Investors who fear being left out of a winning bet and start buying into it because they see everyone else is (e.g. Asch, 1955) may be in for a very unhappy surprise. Remember, just because “everybody” is in a certain investment vehicle doesn’t mean that it’s the right one for you.
4. Projection bias. People directly project their current emotional state into the future, forgetting they will probably feel differently when the future becomes the present. This means we have a tendency to make investment decisions based on present desires, even if they override our long-term goals. (e.g. Grable, Lytton & O’Neill, 2004). If you have ever called your financial advisor and said “Sell it all!” or “Put everything I’ve got into gold,” you suffered projection bias, generally accompanied by sub-par results.
5. Recentness bias. Similar to projection bias, we’re inclined to use our recent experience as the baseline for what will happen in the future (e.g. Fudenberg& Levine, 2013). This is what happens in a bull market run when people appear to forget about cycles and keep buying as if the market will continue to go up, or buy shares in a cruise company following an unbelievable family vacation.Then when things don’t pan out, they’re shocked. By the way, recentness bias has a nasty double edge: When the market is down, the feeling it will never go back up again leads many investors to miss the eventual rally.
6. Anchoring effect (relativity trap). The mind is biased by first impressions, and this bias is why one price acts like an anchor in our thinking (e.g. Strack and Mussweiler, 1999). In investing, the anchoring effect works like this: Once investors have “that price” in their mind, it acts as an anchor, and they wait too long for an investment to return to the price they purchased it at rather then getting rid of a loser. In addition, the anchoring effect can result in missed buying opportunities as investors wait for an investment to return to “the price” before considering making their buy.
7. Optimism bias. This means we tend to look at things that are a long way away with optimism, but the closer the outcome gets, the more pessimistic we get (e.g. Sweeny &Krizan, 2012). This can manifest itself in taking unnecessary risk in retirement savings when we’re young (“It will all work out”) and then panicking and becoming overly conservative when the actual event looms. That’s what I find most pernicious about this bias: It damages retirement saving both coming and going.
8. Fear of losses. This is the tendency to sell things when they go up in price, but hold onto them when they go down. It’s a natural desire to avoid losses and is seen over and over in stock-market trading (e.g. Weber & Camerer, 1998). If you have been a holder in an old, dying tech company for a long period of time, your fear of realizing losses may have kept you invested in what is now a very risky situation.
Fear is one of the most powerful emotions humans are subject to, and it has always posed a challenge for investors. The best way to avoid these and other traps is to maintain a focused eye on the horizon and implement portfolio decisions with a longer time frame rather than react to market noise.
Fear should never be the driving force behind an investment decision. A financial advisor can be invaluable if you need help avoiding behavioral traps or making and sticking to portfolio decisions. He or she can temper not only fear and uncertainty but also the other extreme of euphoria and exuberance when making market decisions.
Jim Cahn is Chief Investment Officer of Wealth Enhancement Advisory Services, the RIA arm of Wealth Enhancement Group. Contact him at email@example.com.
Originally published on forbes.com