4 Psychological Blind Spots That Affect Your Portfolio
Learn how to avoid having your emotions derail your financial plans.
A gentleman recently came into my office for advice. He plans to retire in two years and is confused about how to position his investments for retirement. I looked at his portfolio and discovered 100% of his money was invested in one stock—his company's stock.
He admitted, "I know I have to do something, but it's hard for me to make a decision."
This gentleman has a classic case of the blind spots known as "decision overload" and "loss aversion." Common behaviors. Do you share them?
Here are four investment blind spots that may be all too familiar to you.
1. Decision Overload
If you're preparing for retirement, or recently retired, you face a ton of decisions. Who's the right financial professional for me? What financial products can help put me on the path to financial independence? How do I protect my savings?
Being flooded with so many questions can be overwhelming. There's pressure not to mess up. It's a recipe for procrastination—analysis paralysis. As a result, many people do nothing. But that choice can be harmful for your retirement strategy.
The good news is, if you recognize this inhibiting emotion in yourself, you can proactively take steps to move forward with better financial decisions.
2. Loss Aversion
You work hard for your money and make sacrifices to accumulate a nest egg. Nobody likes to lose money. It's human nature to have an emotional attachment to the cash you've saved over a lifetime.
But the stronger our emotional attachment is to money, the more likely we are to make poor financial decisions.
Loss aversion is all about emotion and it affects our behavior. People feel cash losses much more strongly, more emotionally, than they feel gains. The motivation to avoid losses is twice as strong as the desire to make gains, according to Nobel Prize-winning psychologist Daniel Kahneman. His work has helped create more understanding about the psychology behind our money choices.
Loss aversion can pressure people to:
1. hold on to a sinking investment too long because they hope it turns around; and
2. sell gaining investments too fast because they don't want to lose the gain.
At its most extreme, loss aversion leads to the dreaded "sunk cost fallacy." That means you hold on to an asset until it's worthless. Think of Enron and WorldCom.
What's the remedy? Remove the emotional attachment to your money. I know, easier said than done. Many folks think, "Who could watch my money as closely as I do?"
But if you recognize the loss aversion emotion in your mindset, consider talking to a financial adviser about managing your investments. Advisers don't fall in love with an investment—there's no emotional attachment—and that professional detachment helps allow them to manage money objectively.
3. Hindsight Bias
You've heard the saying "hindsight is 20/20." This is a common problem among consumers. Many believe you can predict how certain investments and other financial products will perform in the future based on their past.
For example, a year ago Apple stock was selling for about $130 a share following a solid two-year run-up. In July 2015, stock analysts described Apple as a strong stock heading toward $150 a share.
That seemed like a reasonable prediction, especially if "hindsight bias" is part of your thinking. Today the stock is selling for less than $100 a share.
No one can predict the markets, and hindsight is not always 20/20 when it comes to your investment portfolio. It's important to remember that past performance is not indicative of future results.
4. The Herd Mentality
I know a bunch of guys who work together and talk about their money every day. They're managing their own 401(k) dollars and comparing notes: "You need to get into this stock and dump that one." "This one has done great for me."
Suddenly, all of their buddies hop on to an investment regardless of their age and even when it's not in their best interest.
The herd mentality spurs people to buy a stock when the price is going up, and becoming overvalued, for no better reason than "other people are doing it." It's the "hot stock."
This psychological blind spot makes investors buy high and then the market corrects itself. Don't get swept up in the emotion of the herd.
Become a Rational Investor
Money is emotion-based. It's natural for these emotions to creep into our money management, but they can produce irrational decisions.
That's why I practice what I preach. I hire wealth managers to make the buys and sells of my own investment portfolio. I help with asset allocation, but then I hand off my money to another investment team.
It's worth it to me, because when I take my emotions out of financial decisions, I have a better chance at getting a return that more than offsets the small management fee. I trust them and don't have to worry about my own emotions getting in the way of sound decisions.
The gentleman at the start of this article with all of his money in one stock has taken the first step to removing the emotions that cause financial mistakes. He knows he has some blind spots to deal with and is now seeking the help of a financial adviser.
It's our job to educate consumers about these psychological blind spots affecting financial decisions. Armed with knowledge, you can be a smarter, more rational investor.
Curt D. Knotick is a financial adviser, insurance professional and chief executive officer at Accurate Solutions Group LLC. He has more than 25 years of experience in the financial industry.
Investment advisory services offered through Global Financial Private Capital, an SEC Registered Investment Advisor.
Global Financial Private Capital (GFPC) and GF Investment Services (GFIS) have no affiliation with the news agencies represented here and the views expressed do not necessarily reflect the views of GFPC or GFIS. GFPC and GFIS make no representations or warranties about the accuracy, reliability, completeness or timeliness of the content and do not recommend or endorse any specific information contained therein.
Dave Heller contributed to this article.