6 Ways It Can Block The Path To Long-Term Wealth

As the US stock market experiences its first significant correction in a few years, it seems like the time has come to discuss some of the psychological biases that can negatively influence investor behavior:

1. Approval

We all tend to actively seek out information that supports opinions we have already formed and digest facts that fit our own worldview. Investors generally ignore or avoid reading critical opinions and reports on investments in which they already hold large positions and seek confirmation from analysts and the media that the initial decisions they made to buy and hold are always good. Just as great leaders will listen carefully to those they disagree with, great investors should listen to the grunts of bears going in the opposite direction to the thundering bulls.

2. Anchor

The price an investor initially pays for a stock can act as an unfortunate psychological “anchor” that can lead to irrational decisions about the future value of the company. A confident investor buys what he thinks is a great company at a perceived bargain price of $100 per share; only to see bad news about the company and the economy, sending the price down to $50 over the next two months. The fact that the investor paid $100 upfront may lead to an irrational assessment of the company’s potential at its new “Awesome!!” price. I will double my position at this new price! In reality, the initial price of $100 paid by the investor has nothing to do with the growth potential of the business if purchased at its new price of $50, but is perceived as a good price. market based on the much higher price paid initially.

3. Myopic loss aversion

Investors must manage the battle between fear and greed in their head and stomach to be successful in accumulating long-term wealth. Unfortunately, the fear of loss is usually a more powerful force that overwhelms many investors during periods of steep stock price losses. Even if they don’t plan to liquidate the investment for decades, many investors panic during corrections and bear markets; causing them to miss the often brutal price recovery that ensues. Warren Buffett described his legendary approach to value investing this simple way: “When the herd is greedy, I’m scared, when the herd is scared, I’m greedy.”

4. Playing with house money

Casino operators and professional poker players know this behavior very well. A novice gambler travels to Las Vegas with $5,000 in his pocket to gamble. Their decisions to hold or fold in a given hand can be greatly influenced throughout the night depending on whether they have more or less than the initial $5,000 in their pocket. If they “win” $3,000, they are more likely to make aggressive bets with the $3,000, which is “house money,” than if they had less than the initial $5,000 in their pocket .

Investors often react the same way. Consider two investors: one who bought $100,000 worth of Amazon stock at $30 a share two years ago. The second bought $100,000 worth of Amazon stock at $50 per share today. If the price drops back to $40 in the next few months, the first investor may be less likely to sell as they are still playing with some “house money”.

5. Overconfidence

This is the “Lac Wobegon” effect. Even though study after study has shown that it is virtually impossible to time the markets and be invested only when prices are rising, many investors overestimate their own abilities. In an effort to feel in control and “in the know”, many investors subject themselves to unnecessary transaction costs and income taxes and miss out on much of the appreciation in the markets by trying to be absent when prices fall. The sad reality is that many investors in a given stock or mutual fund earn far less over time than the actual investment returns…due to trading investments and chasing winners over the past year .

6. Framing

Decisions to invest in a business can be greatly influenced by the way statistics are presented. If I told you that I once combined with a teammate to score 55 points in a single college basketball game, you’d assume I’m a much better player than if I had “framed” the stats with the rest of the story he scored 49 and I only scored 6!

A company’s presentation of itself is never random. “Our profits jumped 150% and our revenue increased 50% over last year” sounds great until you find out that last year was the worst financial year in the history of the company. ‘business. “Our stock price recently hit an all-time high of $100 per share” sounds great until you learn that the price hit $99 ten years ago.

The magic of a consistent and repeatable investment process

I am often asked what “secret sauce” we use at Golden Pond Wealth Management that gives us the ability to grow and protect our clients’ wealth over the long term. Well, there is no secret sauce or magic formula. Quite simply, successful long-term investing requires both us and our clients to make a strong commitment to checking our emotions, ego, and the “6 Psychological Biases” in this article at the door. Instead, we adopt a repeatable process that’s methodical and plain vanilla; customized based on client’s risk tolerance, tax bracket and balance sheet; and which has stood the test of time for many decades.

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The content of this document is provided for general information only and is not intended to provide specific advice or recommendations to any individual. All performance referenced is historical and does not guarantee future results.

Investing involves risks including price fluctuation and loss of principal.

Any company names shown here are for educational purposes only and not an indication of commercial intent or a solicitation of their products or services. LPL Financial does not provide research on individual stocks.

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