While most people think that they are rational, many studies have shown that investors tend to make the same mistakes consistently when dealing with their finances because they let their emotions get in the way of making good decisions. There are several common emotional mistakes that most people make.

 

One way in which investors lower their potential returns is through status quo bias, basically the tendency for people to do nothing rather than make an active choice to change. A related theory is the endowment effect, where people tend to hang on to whatever default they have been handed. Due to a lack of desire to make changes, investors often suffer worse returns because they are not willing to take advantage of new opportunities that emerge or readjust their portfolios as their situations change. A big driver behind this tendency is fear of regret or making a bad decision.

 

Another emotional response that reduces investment returns is the concept of anchoring, where an investor decides that a security is worth some fixed price, generally the price that the investor paid for it. Because this anchor exists, the investor is less likely to sell a security at a loss because that that action would be effectively admitting a mistake. People do not like to admit mistakes and so tend to hold on to securities in hopes that they can at least break even. This can cause people to retain securities that continue to perform poorly or to pass up better opportunities.

 

Investors often suffer from loss aversion. Most people would rather make less money than risk losing money. Because of this fear, many people do not take enough risk in their portfolios, lowering their returns over time. Paradoxically, loss aversion tends to be the worst after already enduring a major loss, such as after stock market crashes. This results in investors making the mistake of selling low and missing potential rebounds. Fear is a major driver of investor behavior and can be the cause of poor investment decisions.

 

A lot of what drives investment decisions is a cycle of fear and greed, which can lead to herding behavior. In herding behavior, people flock to the same investment because it has been working. Momentum investing is based on buying at a high price and hoping to sell to someone else at a higher price. Herd behavior leads to bubbles in different asset classes, such as technology stocks or real estate. As people see others making money by investing in certain assets, they want to also make money and fear being left behind. As such, people choose to buy assets that may not be good longer term ideas because they want to keep up with their friends.

 

In san francisco financial advice is available from any number of sources. A good registered investment adviser will be able to help sort out good ideas from bad and curb an investor's emotional decisions that can lower returns in the future. fee-based advice is best, as the adviser and the investor both make more money when the advice results in better returns and more money. Impartial advice helps counteract some emotional forces and provides a good way to stay rational.