Don't invest with your heart, invest with your head

Emotions make us lousy investors. People, as humans, tend to act in emotional ways during tough or exciting times. When people give in to emotions--investing with their hearts instead of their heads--they get lousy results.

If you've refused to sell a losing investment, bought because everyone else was, sold because a stock's price went down, picked investments because they seemed safe, or sold because the economy looked dreadful, then you've invested with your emotions. Don't feel bad, everyone fights and succumbs to this at some point.

The field of behavioral finance has clearly shown that we humans suffer from several biases that lead us to make unwise investment decisions.

For example, there's anchoring bias. If you hold an investment waiting for it to get back to the price you paid, you're suffering from anchoring bias. If you wait to buy an investment until it declines back to the price you could have bought it at (and regret not having done so), that's anchoring bias again.

Another bias is called recency bias. This is the tendency to think that recent events are more likely than they are (and that distant events are less likely). Someone who buys hurricane insurance because a bunch of hurricanes seem to have hit recently is suffering from recency bias. Someone who drops earthquake coverage because an earthquake hasn't happened in a while has been hit with recency bias.

Loss aversion is one of the most common biases. It happens when people refuse to sell an investment because they don't want to "book the loss." People feel losses more keenly than gains, and they usually need twice the gain to make up for a given loss. This can lead people to make bad investment decisions by holding on to something they should sell.

Then, there's the endowment or halo effect. This happens when one particular good attribute overwhelms all other attributes. Many people still see GM as a great company because it was in the past, even though there's a lot of evidence it isn't anymore. It can also happen the other way around, when one particular bad attribute overwhelms all good attributes. Many assume a company whose stock has gone down a lot must be bad, even though it may have many excellent characteristics. The price drop seems to overwhelm everything else.

Finally, there's overconfidence. When asked, we all claim to be above average drivers, kissers, and investors, but this isn't Lake Wobegon and everyone can't be above average. It's hard for us view ourselves objectively, and so we make unwise investments when we feel more confident than the facts suggest.

The way to fight these biases is simple, but not easy: discipline. If you use strict criteria to buy and sell investments and act on that criteria, you can fight these emotional biases and win. This will greatly improve your results. Even better, If you'd prefer to let someone else be disciplined for you (I'm not unbiased on this suggestion), then unemotionally select an advisor that can act with discipline on your behalf.

Invest with your head instead of your heart, and you'll get dramatically better investment results over the long term.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.