OCEAN CITY — Do you blame your investing blunders on bad luck? A bad market? There’s evidence that poor performance is often the result of ingrained behavior patterns.
Experts in behavioral finance have identified certain predictable patterns of behavior that lead investors to make the same mistakes over and over. Here are six common behaviors that can deal your investments a substantial setback — and some changes that can help you avoid them.
Last week, we took a look at three reasons, and here are three more.
Hanging onto your losses
One of the hardest things for many investors to do is to sell a loser. In fact, some investors will sell winning investments and hold on to losing investments on the theory that they haven’t really lost anything until they actually sell. Researchers at the University of California have found that this approach often leads to the opposite of what was intended: Loss-averse investors sell their top performers, hoping their losing investments will rebound. In fact, the exact opposite often happens. The losers continue to sink and the winners continue to climb — after they have been sold.
But if you have identified an investment that has clearly underperformed over time, consider taking the loss and choosing another investment with the potential for positive returns. If you keep waiting to break even, you may lose even more ground.
Taking Too Much Credit
Behavioral finance studies show that investors often process rational information in an irrational way. For example, investors have a tendency to overreact to their own success — especially when the broad markets are climbing and almost any investment has the potential to rise. A lot of investors misjudge their skill level in a rising market, but don’t know what to do in a down market. One strategy is to maintain your long-term perspective, even when the markets turn downward. And seeking help from a Financial Advisor can help you make informed decisions.
Diversification has proven to be one of the single most important steps you can take toward long-term investment success. You know better than to put all your eggs in one basket. But even if you invest in a number of mutual funds, you may not be as diversified as you need to be. Make sure your funds don’t overlap with too many holdings in similar assets. It is important to have exposure to many different markets and sectors. Consider assets that can help reduce the volatility of your portfolio, because the same economic conditions that cause some to fall may cause others to rise. Diversification can reduce volatility in your portfolio and reduce risk, while providing the potential for investment growth (but it cannot ensure a profit or protect against loss).
Look at your own investment habits
When you look at these six behavior patterns, you can see that most are based on emotions. Is that any way to make effective investment decisions? If you recognize yourself in any of these behavior patterns, resolve to break those habits. Remember, it’s not just the choices you make, but the mistakes you avoid that can help you invest successfully over time.
(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)