A heads-up to anyone with a 401(k): With the stock market near record highs, the biggest threat to your hard-earned retirement savings could be you.
Your emotions, biases and other mental miscues can lead to psychological traps that cause you to make bad investment decisions.
After making a fortune in hot stocks such as Amazon or Netflix, for example, you might fool yourself into thinking you're as talented an investor as billionaire Warren Buffett. Or you may get stuck on the idea that the longest bull market in history will last forever, or worry a steep drop is imminent. You might also make the mistake of only seeking information that confirms your personal view on where markets are headed.
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The emerging field of behavioral finance, which looks at the relationship between investor psychology and the money-related moves people make, chronicles many of the human traits that can cause errors in decision-making.
"To keep it simple, behavioral finance is the reality of humans being human and making mistakes," says Woody Dorsey, president of Market Semiotics, a Castleton, Vermont, research firm that studies and diagnoses the habitual cognitive errors investors make.
Here are four ways investors' flawed thinking can lead to blunders and how they can avoid those mistakes.
Avoid 'overconfidence'
Nine years into a bull market, it's easy for investors to credit their savvy stock picking for big gains in their portfolios, rather than acknowledge the long climb in stock prices that has pushed the Standard & Poor's 500 index up 330 percent since March 2009.
Such overconfidence occurs when people think they are better informed and better investors than they are.
"They think, 'I made an investment and it went up; I am so smart,' " says Michael Pompian, CEO of Sunpointe Investments in St. Louis and author of "Behavioral Finance and Wealth Management."
Citing the old Wall Street adage, "don't confuse brains with a bull market," Pompian says investors who think too highly of their own ability tend to take "foolish risks," like buying hot stocks without doing proper research, trading too frequently and straying from their financial plans. Often, this risky behavior results in losses when markets eventually fall, he adds.
Tip: Keep reminding yourself that beating the market is hard. Only 36 percent of active U.S. stock pickers at mutual funds posted better returns than the market benchmarks they're compared to in the year ending in June.
Not seeking alternative opinions
Known as "confirmation bias," investors can run into trouble when they only seek out information that fits with their bullish or bearish outlook for the stock market.
"Once you have an investment idea, you look for reasons why it is right and don't actively look for reasons why it is wrong," explains Terrance Odean, a finance professor and behavioral finance researcher at the University of California, Berkeley.
This strategy is particularly dangerous around market highs. Investors who believe the bull has room to run and the economy will grow even faster, for example, might pile into the stock market too aggressively. That creates risk of losses if they're wrong.
By contrast, investors who pay too much attention to headlines warning of a coming market plunge or 1987-style crash may reduce their stock holdings and boost their cash too early, missing out on potential gains if stocks keep rising.
"Try to seek out information that goes against your beliefs so you can have a cross check on your optimism and pessimism and make better, more informed decisions," Pompian says.
Tip: If you're bullish on the market, focus on news articles and Wall Street pundits who warn of a coming calamity. Analyze whether the downbeat views have validity.
Betting the trend will continue
"Recency bias" is when investors believe the current trend will continue. That means investors today could err by betting on an ongoing rise in stock prices in which the market rarely has violent swings.
Movements in the stock market are hard to predict. So a wager on things staying the same for too long can lead to complacency and set up investors for disappointment if the market tanks, turns turbulent or when a hot sliver of it, such as top-performing tech stocks, suddenly cools.
"It's good to remember that crashes mostly come out of nowhere," says Hersh Shefrin, professor of behavioral finance at Santa Clara University in California, citing crashes in 1929 and 1987.
Tip: Think back to other market peaks that ended badly, such as the 2000 internet stock bust or the market meltdown in 2008 and 2009. It's a good reminder that bull markets are followed by bears.
Selling winners too early
The so-called "disposition effect," or tendency for investors to sell their winning stocks and hang on to losers, can also prove harmful in a bull market. Even though this bull, now the longest in history, seems to have entered its later innings, the economy is still growing at its best pace in four years, and the consumer is in good shape due to low unemployment and rising wages.
"Some investors are selling their stocks because they fear a pending bear market," Pompian says. "The flaw in this thinking is that the economy is strong and there are few signs that a recession is imminent."
There's always some opportunity for investors to do harm to themselves, Odean says. That's why he says investors should avoid trying to time the market. A better strategy, he says, is to make financial decisions in "times of calm reflection."
"When the market does get really wild, that's not the time to be making investment decisions," Odean says. "Once a year, you're better off asking, 'Do I have the asset allocation I want?' rather than trying to predict where the market is going or what the next hot stock will be."
Tip: If you own a top-performing stock, keep a close check on its business health, and if earnings, sales and market share remain strong, there may be a good case to keep it.
