Emotionally Trapped in Bull Markets: Uncovering Hidden Costs of Volatility
The Hidden Cost of Volatility Drag
That said, many investors fail to consider the often-overlooked impact of volatility on their portfolios.
Behavioral Finance 101
Behavioral finance attempts to explain how and why emotions and cognitive errors influence investors and create stock market anomalies such as bubbles and crashes. But are human flaws consistent and predictable such that they can be a) avoided and b) exploited for profit? By understanding these patterns, investors can make more informed decisions.
Common Mental Mistakes
1. Overconfidence: 19% of people think they belong to the richest 1% of U.S. households. This self-assessment bias can lead to poor investment choices. 2. Projecting the immediate past into the distant future: Many investors mistakenly believe that their current market performance will continue indefinitely. 3. Herd-like behavior (social proof): The desire to be part of the crowd or an assumption that the crowd is omniscient can drive irrational decisions.
Misunderstanding Randomness; Seeing Patterns That Don't Exist
5% of lawyers in civil cases believe that their side will prevail. This misplaced confidence is often based on incomplete information. 6. Doctors consistently overestimate their ability to detect certain diseases. As a result, many investors are misled into investing in companies with uncertain financial prospects.
Commitment and Consistency Bias
7% of new business owners think their business has at least a 70% chance of success, but only 39% believe any business like theirs would be likely to succeed. 8. Graduate students were asked to estimate the time it would take them to finish their thesis under three scenarios: best case, expected, and worst case. The actual average turned out to be 55.5 days.
Anchoring on Irrelevant Data
9% of mutual fund managers, analysts, and business executives at a conference said that the ratio is always approximately 2:1 when describing how much money they would have at retirement. 10. 86% of my Harvard Business School classmates say they are better looking than their classmates can lead to straying beyond circle of competence and excessive leverage.
Information and Overconfidence
11. Sometimes additional information can lead to worse decisions, overconfidence and excessive trading. 12. Experienced analysts have an imperfect understanding of what information they actually use in making judgments. They are unaware of the extent to which their judgments are determined by a few dominant facto.