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10 Mind Tricks That Are Keeping Your Clients In The Red<br><br>

How investors go about making decisions in uncertain and volatile markets can have long-lasting implications, especially when bias and emotion enter in. The field of behavioral finance has shown that human beings can’t be presumed to take the most logical, rational approach to investing. So if not logic, just what is affecting our decisions?

A recent report from Robert W. Baird & Co.’s Private Wealth Management Research team outlines psychological and social factors that affect how we make financial decisions.

Be aware of these factors to help you avoid some psychological pitfalls that regularly affect professional and amateur investors alike.

Source: Robert W. Baird & Co.’s Private Wealth Management Research
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1. The mind “anchors” where it shouldn’t.<br><br>

Wineries use prices to signal quality by listing reserve wines at such high prices all other bottles appear attractively priced – but are they really attractively priced? You can’t tell if something is a good deal merely because it’s on sale or costs less than some other arbitrary “anchor” point.


Tips and Advice:


Watch out for anchoring your judgments on a price or valuation that may be irrelevant – like past performance or 52-week highs/lows. Use multiple benchmarks or reference points to better triangulate. Try to understand why something is priced the way it is – there is usually a good reason. Realize that the margin of error in any decision is often larger than you anticipate.
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2. The mind wants to be right and avoid being wrong.<br><br>

People like to be right and seek out information to prove they’re right. People also like to avoid the embarrassment of being wrong. So, they rationalize away whatever information that suggests they’re wrong.


Tips and Advice:


Don’t get attached to a particular investment opportunity. Employ objective screens when selecting investments. Play devil’s advocate with yourself. Ask disconfirming questions. Use trusted external resources as sounding boards.
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3. The mind prioritizes information that’s prominently available.<br><br>

When purchasing a car, are you more likely to purchase based on 1,000 anonymous consumer reviews that rate it highly – or based on complaints of your neighbor, who just purchased the car and it turned out to be a lemon?


Most people weigh the neighbor’s claims more heavily despite it being a sample size of only one because it represents a more salient example.


Tips and Advice:


To train yourself away from this “availability bias,” keep accurate records of why an important financial decision was made and refer to it to help prevent future mistakes. Don’t let abnormal, one-off events dictate your strategy.
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4. The mind can see 20/20 in hindsight.<br><br>

How could anyone have missed that there was a bubble in the housing market? Wasn’t that obvious? Hindsight is 20/20 and revisionist history is rampant when money is on the line, making people believe that an outcome is more obvious once it is already known. However, after-the-fact observations mask the uncertainty that occurs in real-time market analysis.
Tips and Advice:


Remain focused on the long-term and don’t let daily market volatility or events drive emotions.
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5. The mind loves to play “mental accounting” games.<br><br>

Do you treat “found money” differently than earned income? Many people spend tax refunds or bonuses more frivolously, even though money is money. Watch out for mental accounting by subjective criteria. Another example is treating a prior purchase as a sunk cost and writing it off in your mind – the way people do when failing to redeem pre-paid Groupon coupons.
Tips and Advice:


Take a holistic view rather than arbitrarily segmenting your assets. Create a financial plan that includes all your assets. Focus on both sides of your personal balance sheet when making decisions.
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6. The mind fears losing more than it values winning.<br><br>

“Prospect Theory” in behavioral finance suggests that people fear losing about twice as much as they value winning. So people are loss-averse, rather than rational in choosing the highest expected gain or lowest expected loss.


Here’s where emotion can really turn logic on its head. Prospect Theory shows that when posed with expected gains, people are risk-averse – but when posed with expected losses, people actually become risk-seeking because they hope to avoid a big loss. This psychological tendency makes it very difficult for financial advisers to help clients steer a steady course in the face of market losses!
Tips and Advice:


To combat loss-avoiding emotions, try to spread out a gain as opposed to realizing the entire amount immediately. When faced with potential losses, sometimes it is easier to take one large loss and move on than to prolong it into a series of smaller losses. Don’t become overly aggressive when trying to make up for market losses!
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7. The mind wants to recognize positives immediately and defer negatives until later.<br><br>

Have you ever sold winning stocks too quickly and held losing stocks far too long? Investors often feel satisfaction when their investments show a profit and look to lock in those gains. Conversely, the pain of feeling regret will prompt many to hold on to a losing position in the hopes that it will break even.


Tips and Advice:


To avoid cutting short great investments and holding hope for poor ones, use set criteria for purchasing or selling securities. Incorporate new information as it comes available. Employ formal or informal stop loss limits. And, remember Warren Buffet’s counsel: “The most important thing to do when you find yourself in a hole is to stop digging.”
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8. The mind is prone to overconfidence.<br><br>

How many times have you heard someone tell you that they are 99% sure about something? How many times were they incorrect? Probably more than 1%. Overconfidence doesn’t mean everyone is a narcissist – it just means we tend to be too confident in the accuracy of our own judgments.


Tips and Advice:


Be aware of areas you’re skilled in – and those where you aren’t. Allow third-part experts to invest on your behalf in areas where you don’t have expertise. Be honest when attributing success and failure and set realistic expectations.
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9. The mind expects reversion to the mean even when odds are steady.<br><br>

The “Gambler’s Fallacy” is the term for the presumption that because the roulette game landed on red an amazing 11 consecutive times the likelihood of breaking that streak – and landing on black – more than 50/50. The fact is the likelihood of black is always 50/50, regardless of what happened on the previous roll.


In investing, the parallel concept is expecting reversion to the mean. People often assume that outperforming or underperforming securities will somehow revert back to average (the mean) over time. Sometimes this happens—but sometimes not! Some investments are simply really good or really bad.


Tips and Advice:


Try to separate chance from skill. In situations of chance, know that previous outcomes should have little bearing on your decisions. When viewing past performance, try to understand the drivers of those returns and whether outperformance can continue or underperformance will correct itself.
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10. The mind tends to follow the herd.<br><br>

“Groupthink” stems from the fact that people feel more comfortable making decisions that they see other people making. This false sense of comfort can lead to suboptimal outcomes – to the point of asset bubbles and crashes, including the most recent housing crisis.


It’s one thing to fall victim to a fashion faux pas when conforming to social pressures. It’s quite another thing to put your wealth at risk because of the actions of others.


Tips and Advice:


Make decisions based on what is most suitable for your investment style and financial situation. Think like a contrarian by asking what everyone is missing instead of fearing that you are missing out. Do your own homework or engage a third-party expert to investigate ideas on your behalf.
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