We may be investing for distant goals, like our toddler's college education and our own retirement. Yet we often fret over short-term market performance. And, as always, there's a fair amount of that going on right now.
Emboldened by your investment gains over the past two years? Unnerved by this year's market swings? Consider some of the mental mistakes identified by academics who specialize in behavioral finance. Here are five such mistakes:
Overconfidence. We tend to think we're smarter than we really are and that we know more than we really do. This overconfidence can climb along with the markets, leading some folks to trade excessively and take on too much risk.
Hindsight bias. In retrospect, it might seem obvious that stocks would come roaring back from the drubbing of 2008 and early 2009. Indeed, it's easy to forget all the economic uncertainty that existed at the time and convince ourselves that we foresaw the rally. This hindsight bias can further bolster our confidence, possibly prompting us to make bold market forecasts today and then act upon them.
Confirmation bias. We tend to latch on to evidence that supports our beliefs, while discounting contradictory evidence. For instance, bullish investors will ignore bad economic news, while bearish investors will dismiss positive developments.
Recency. We often read too much into recent market action. When stocks fall, we tend to extrapolate the trend and assume shares will keep on falling. When prices rise, we may assume they'll continue climbing.
Loss aversion. Many investors hate to sell at a loss, instead hanging on to losing positions, hoping to get even, then get out. In fact, if the current rally continues, some folks may start unloading stocks, figuring they have recouped their losses from 2008 and early 2009--or got close enough--and they ought to sell before the market potentially plummets again.
