Investors: Don’t Be Your Own Enemy

serious businessman thinking through his decisions

Don’t Be Your Own Worst Enemy
By Sean C. Mahoney, CFP®

One of the most well-known investors of the 20th Century, Benjamin Graham, said that “the investor’s chief problem—and even his worst enemy—is likely to be himself.”

What Graham understood—and modern research is catching up to—is the idea that we all have emotions and biases that affect our decision-making. The innate wiring built to survive pre-modern times can be counterproductive in our modern world, especially when it comes to investing.

Let’s take a quick look at a few of the human emotions and biases that can adversely impact sound investment decision-making.

Investor Emotions and Biases:

Fear and Greed
These are the two most powerful emotions that move investors and investment markets. Each emotion clouds our capability for rational and dispassionate decision-making. They are the emotions that lead us to believe that prices may continue to rise (think the Tulip price bubble of 1636 where at the height of the bubble, tulips sold for approximately 10,000 guilders, equal to the value of a mansion on the Amsterdam Grand Canal) or that everything has gone so wrong that prices may not recover (think of the recent Credit Crisis of 2008 – 2009).

Some investors have found a way to conquer these emotions, be brave when everyone else is fearful, and resist the temptations of a too-exuberant market.

Overconfidence
Peter Bernstein, a noted economic historian, argued that the riskiest moment may be when we feel that we are right. It is at that precise moment that we tend to disregard all information that may conflict with our beliefs, setting ourselves up for investment surprise.

Selective Memory
Human nature is such that we tend to recast history in a manner that emphasizes our successes and downplays our failures. As a result, we may not benefit from the valuable lessons failure can teach. Indeed, failure may be your most valuable asset.

Prediction Fallacy
Humans have an innate desire to recognize patterns and apply these patterns to predicting the future. We erroneously believe that because “A” occurred and “B” happened that if “A” happens again, we can profit by anticipating that “B” will repeat. Market history is littered with examples of “rules of thumb” that have worked until they no longer worked.

Financial markets are complex and unpredictable. Our endeavors to tap their opportunities to pursue our financial goals are best realized when we don’t burden the enterprise by blindness to the inherent behavioral obstacles we all share.

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