Investing Sins

Our thinking is strongly influenced by what is personally most relevant, recent or traumatic.

One consequence of being emotionally invested in the performance of the stock market is overreacting to new market information.

For many investors, little was more traumatic than the events of the 2008 financial crisis. The S&P 500 Index was down 37%.¹ But, the following year, in 2009, the market bounced back to 26.5%.² After 2009 ended, Franklin Templeton conducted a survey asking people how they thought the market performed that year.³ Likely due to the traumatic events of the recent crisis, two-thirds of respondents incorrectly thought the market was down or flat in 2009.⁴

Following the crowd because of the fear of making mistakes or missing opportunities.

Throughout history, investors have faced strong temptation to join the investment bandwagon based on emotions, rather than a sound financial strategy. The illustration to the right shows four well-known financial bubbles. During the run-up of these bubbles, investors bid up the prices of tulip bulbs, stocks and real estate to unsustainable levels. But, even more quickly than they expanded, these markets burst and contracted, leaving the herd scrambling.
 

The pain associated with a loss is much more intense than the reward felt from a gain.

In fact, studies show that the pain of a loss is almost twice as strong as the reward felt from a gain. Put another way, losing one dollar feels twice as bad as winning one dollar feels good.

As emotional investors, we tend to make decisions to avoid the pain of loss. During the last two market pullbacks, investors panicked and pulled their money out of the market—contributing to large increases in cash and cash equivalents. To avoid more losses after a market crash, fearful investors may be tempted to move their investments to a place they perceive as a safe haven—such as cash or cash equivalents.

Focusing too heavily on one piece of information when making decisions.

Anchors can influence how we feel about the progress of our investment plans. A hypothetical investor may say they want an 8% return over the life of their portfolio. However, investing often involves volatility. Many investors anchor to market high points, setting unrealistic future return expectations. If the market drops, they may feel they’re doing poorly despite still being largely on track to reach their long-term goals.

When Franklin Templeton surveyed investors about their portfolio return expectations over a five-year period, the median response was 10% annually. But, when presented with a hypothetical market that was up 20%, median return expectations increased to 20%. The hypothetical strong-performing market anchor caused investors to expect stronger returns that matched the market.

Overvaluing immediate rewards at the expense of long-term goals.

When a short-term reward is staring us in the face, we often give in to the temptation of instant gratification. The tendency to focus on the now can be seen in our national savings rate. As shown on the right, people have recently been saving less than the long-term average.