We are now on fourth and most important principle in setting ourselves up for long-term investing success: controlling investor behavior. Controlling investor behavior is the most important of the principles because it is the one that can cancel out the positive effects of the previous three.
It’s not your fault that we commonly make bad investment decisions based on emotions. It’s ingrained in your DNA! There are many behavioral biases in investing that are rooted in human survival tendencies. Because it has served us well in the past – think of being face to face with a lion! – when faced with certain stressful situations, we go into fight or flight mode. Disciplined, unemotional investing goes against how our brains are wired.
Even if you understand these tendencies ahead of time, it is still difficult to remove ourselves emotionally and do what the evidence says we should do. Let’s look at three of these biases.
Herd mentality speaks for itself. It is when a majority (or what seems like a majority) of participants are either buying or selling, and you feel you must join in so you do not miss out.
Confirmation bias is one that can be related to the current election. With confirmation bias, we tend to favor evidence which supports our beliefs and ignores any evidence to the contrary. If you tend to lean far left or right politically and your only source of news comes from networks or publications that lean the same way, you are probably experiencing confirmation bias.
Lastly, recency bias is when you give more importance to recent events than what history has shown you should. For instance, after the financial crisis of 2008-09, many investors were overly cautious with every little pullback even though historic evidence says after a 50% correction, the market is many times likely to go up.
Investor behavior is where I believe an advisor can add the greatest value. The first three principles are technical in nature, but this one is emotional. Having an advisor guide you during a market crash in order to keep the proper asset allocation can add more value to the life of a portfolio than the other three principles combined.
To recap, we have covered the four principles which we believe lead to better investment results. Those principles are:
1) Control Fees
2) Control Taxes
3) Asset Allocation
4) Investor Behavior
If you do not believe that you have the knowledge or time to focus on these four, then it may be advisable to seek help from a fiduciary financial professional.