In the instant gratification world we live in today, planning for the long-term has become a lost art. As a financial planner, keeping clients focused on their long-term goals is one of our top priorities. We know that time in the market matters more than timing the market. While that may sound simple, why do so many investors react emotionally to financial decisions resulting in under performance, stress, and an overall distrust of the markets!?
Behavioral finance has the answers for you. Behavioral finance seeks to combine behavioral and cognitive psychological theory with conventional finance to explain why people make irrational financial decisions. Here are the most common reasons investors make financial mistakes:
- Regret (Loss) aversion bias: wanting to avoid the feeling of regret, experienced after making a choice with a potential negative outcome. This leads investors to take less risk because it lessens the potential for poor outcomes. It also explains the reluctance to sell losing investments to avoid confronting the fact they made a poor investment decision.
- Disposition effect bias: similar to loss aversion, disposition effect bias can lead an investor to hang onto an investment that no longer has any upside or sell a winning investment too early to make up for previous losses. This is harmful because it obviously decreases your return, and also creates unnecessary taxes.
- Recency bias: investors often chase past performance in the mistaken belief that historical returns predict future results. This is accentuated by the fact that the media and the investment companies themselves will increase their advertising when past performance is high in order to attract new investors.
- Self-attribution bias: investors who attribute successful outcomes to their own actions and bad outcomes to external factors. This is a self-protection mechanism, which can lead to overconfidence and unnecessary risk taking.
- Confirmation bias: first impressions can be hard to shake because we tend to pay more attention to information that supports our opinions while ignoring the rest.
Arguably, the most successful investor of our generation, Warren Buffett, claims his favorite holding period is forever. While that may not be a realistic holding period for many, the longer you hold on to your investments, the higher your chances are to succeed. As a matter of fact, if you look at the S&P 500 rolling returns since 1950, you made money 90% of the time if you held your investment for 5 years, 97% of the time if you held your investment for 10 years, and 100% of the time if you held your investment for at least 12 years.*
Talk to your financial advisor to make sure your investment allocation is in line with the amount of risk you are comfortable taking given the time frame of your investment goals. Then keep the odds in your favor by sticking to your investment strategy instead of letting your emotions get the best of your returns.
By Danilo Kawasaki
Vice-President and COO
*All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Securities offered through LPL Financial, Member FINRA/SIPC.
Investment advice offered through Gerber Kawasaki Inc, a registered investment advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which course of action may be appropriate for you, consult your financial advisor. No strategy assures success or protects against loss.
Gerber Kawasaki, 2716 Ocean Park Blvd. #2022 Santa Monica, CA 90405. Contact us at (310) 441-9393.