Loss Aversion and Overconfidence Predict Investing Mistakes

by Miranda Marquit · 5 comments

When it comes to investing, many of us are worried about making mistakes.

After all, your money is on the line and you don’t want to lose any of it. Unfortunately, that very feeling of risk aversion might increase the chances that you make investing mistakes. On the flip side, you are also more prone to mistakes if you are overconfident. Both of these situations can lead to investing mistakes that can cost you big in the long run.

Here are the risks associated with being too risk averse or feeling overconfident:

Investing Mistakes Made by Being Too Risk Averse

One of the biggest issues you’ll run into as a risk averse investor is moving your money into “safer” investments right at the wrong time. Selling your investments during a down market and then putting the money into cash, can cause a couple of problems.

First of all, selling when the market is down leads to locking in investment losses. Next, moving into cash assets means you’re not going to see the same rate of returns. In some cases this risk aversion is compounded by the fact that moving into cash positions doesn’t make sense from a long-term perspective if there haven’t been changes to your spending needs or income interruption with other revenue sources.

Many of the risk averse move into cash when the market goes down, and then decide to buy again when the market starts improving. This is a recipe for selling low and buying high. From a long-term perspective, it often makes more sense to buy more stocks during a down turn because you can get bargain prices and see potentially greater returns during a subsequent recovery.

Take the recent market volatility for example. I know a few guys who were scared of the downturn and moved some money into cash in February, only to see the market zoom back up a good 10% in the last four weeks. The worst part is that these people don’t really track their performances, so they will likely do this over and over again. There’s a reason why we urge everybody to stay the course. Doing nothing is actually not easy, but it’s often the most profitable non-action you can ever take.

Overconfidence Doesn’t Help Either

Another major investing mistake is overconfidence. Those who are overconfident in their abilities tend to trade more. This means that they are more exposed to losses, and chances of losses, because of their frequent trading. On top of the risks that come with trying to time the market or pick winning stocks, overconfidence comes with the cost of trading.

Those who are overconfident are more likely to make frequent trades, and those come with transaction costs. This can further erode your real returns over time as you trade too confidently, and pay the costs.

Long-Term Indexing

While you need to do your own research and figure out an investing plan that works best for you, one of the strategies that can help you take advantage of market performance is indexing. I find that indexing works well for me. Because I am investing in broad-based market performance, it reduces the risk associated with stocks (but doesn’t eliminate it). And if I keep my money in for a couple of decades, I am likely to reap the rewards of higher returns that I wouldn’t see in cash products.

Carefully consider your own situation and decide what is likely to work for you while avoiding the mistakes of too much risk aversion and overconfidence.

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  • Punit Bagaria says:

    I thoroughly enjoyed reading your article on how loss aversion and overconfidence predict investing mistakes. Your clear explanation of these key behavioral finance concepts and their impact on investor behavior was both insightful and engaging.
    Thank you for sharing your expertise on this important topic.

  • Pamela Car says:

    The longer I have been investing,and I have been investing for many years, the more I’m convinced that indexing is the key to a healthy portfolio and a healthy state of mind. Nice article.

    • David @ MoneyNing.com says:

      Good to hear from a fellow indexer. It’s hard to put a price on the peace of mind that indexing provides, and could very well be the best benefit of investing in index funds.

  • freebird says:

    Assuming no change in the long-term trend, volatility during a period of dollar cost averaging will boost your returns because you accumulate proportionally more shares at lower prices. Unfortunately the distinction between volatility and a long-term nose-dive is hindsight. Individuals’ time horizons are different, like if you are guaranteed it will fully recover sometime within the next 30 years, this may be good enough for some but not for others.

    Selling shares at what turns out to be a near-term bottom isn’t necessarily a bad move, for example if your asset allocation had ballooned towards equity from a prior run-up, or if you’ve been fully invested and RMDs force you to sell a part. In either case it’s an overdue rebalancing and while it would be better to do this at more favorable prices, historically it’s been better to risk this outcome than to not play at all.

    Indexing doesn’t really avoid the losers, it merely dilutes their effect. It’s an effective play if you don’t want to take the time to choose, but I believe some of us can get better returns with individual stocks we select.

    • David @ MoneyNing.com says:

      You are right freebird (as always!) Volatility can be your friend in the long run because you will end up snapping up shares when prices are low. I was fortunate recently to buy some international shares at a reduced price before the recent runup. If the market stayed high, I would’ve ended up owning fewer shares (even though I would probably feel better).

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