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Beginning Investor Behavioral Finance

How to Outsmart Your Investing Decisions

The brain can have a hard time processing anything negative, but if you follow your rules-based investing strategy instead of your intuition, you will be rewarded over the long term.

by Anine Sus | May 2024

  • Human emotions impact investing; understanding behavioral finance is crucial
  • Establish rules-based investing strategy to combat psychological biases
  • Diversify your portfolio, check accounts infrequently and exercise patience for long-term success

To become a successful individual investor, you’re going to have to face your humanity. The human brain—which is inherently emotional, biased and acts on intuition—and investing—a primarily quantitative process that dictates our future livelihood—are not easy or fast friends. You might think you know everything about your relationship with money, but until you start investing, you won’t necessarily know how losing (potentially a lot of) money will make you feel.

Behavioral finance studies how psychology affects investors. In order to combat the psychological toll a loss can take, establishing a rules-based investing strategy will help save you and your money from going under when the markets are volatile or one of your holdings is tanking.

Creating a Human-Proof Investing Strategy

Staying disciplined while investing is the hardest and most important part of any strategy. After a few months, it can be easy to say, “Oh well, my money’s not making anything substantial. I might as well take it out of the market and use it for something else.” This is a purely emotional, shortsighted reaction. You chose to allocate money for investing in your future, and now your brain is telling you it’s not going to work because you’re not seeing the long-term potential of your investments. Instead, having rules for when you buy and sell your portfolio holdings will take your psychological biases out of the equation.

There are many investing strategies out there, you just have to find one that you can handle. Once you settle on the rules that work for you, write them down. This will solidify them in your head and make them easy to refer to when decisions need to be made. A simple rule is to sell an investment when the reason you bought it no longer applies. Some investors include sell thresholds as part of their strategy, removing a holding when it’s down by a certain percentage such as 30%. Others don’t wait that long and choose to sell when they’re down only 8%. What kind of loss you and your money are able to withstand is entirely up to you, but be sure to do your own research to see how successful certain strategies have been in the past before jumping in. Though the investment could bounce back, waiting a specified time period (down 30% after one month, one quarter or one year, for example) before cutting your losses will give you time to cool off and keep you from making emotion-driven decisions about an emotionless market.

Diversification is another tool an investor can use to help them ignore the voices in their head! The worst thing you can do is feel overconfident in your or anyone else’s ability to find a good investment. Instead, you should use what is measurable and factual to evaluate potential holdings. Does an exchange-traded fund (ETF) have a good history of returns? How much will it cost for you to hold it in your account? If you’re interested in one sector of the market (like technology) because you have a personal interest in it, but you don’t see those stocks outperforming when you want to invest in them, it doesn’t mean you should completely ignore the sector.

You should also never be investing in only one sector of the financial market for this reason: Different sectors will perform favorably at different times. Here, beginners have the advantage. Daniel Crosby explained in his book “The Behavioral Investor”: “By buying a diversified basket of index funds that covers a variety of asset classes, know nothing investors (who often know a great deal) are likely to beat more than 90% of active managers and have time to focus on pursuits more meaningful than compounding wealth.”

Diversification is an investing technique that acts as a safety net against how the economy might perform. If you have a truly diversified portfolio, you won’t have to worry about which sector of the market is down—ever. Some sectors will be the best performers one year only to be the worst performers the next year. Likewise, certain investment factors won’t always have great performance; growth and value tend to take turns doing well—how polite of them!

How Often Should You Check Your Account?

Crosby states, “Humans are wired to act; markets tend to reward inaction.” If we see red numbers on our brokerage account, our brains will automatically see this as a problem that needs to be fixed. Don’t listen to that pesky brain of yours! It hasn’t yet adapted to what those red numbers really mean. Instead, it’s important to understand that short-term moves in the market aren’t going to matter for longer periods. Things change every day like the weather. The market goes up, it goes down and sometimes it doesn’t move much. Over the long term, we can expect stocks to increase in value as the companies that underlie them profit and grow. The less you touch your investments, the better off your bottom line will be.

Remember, this isn’t just a numbers game with the human brain involved. You can do a lot more psychological damage if you’re always checking on your portfolio. Put simply, if you don’t look at your brokerage account constantly, you’re less likely to see your account in the red. This gives you the peace of mind that the market will smooth returns over time so you don’t have to worry about short-term volatility. It helps to have a rule for how often you will check your brokerage account. You could start by logging in monthly and adjust as you figure out what works for you.

Vanguard founder John Bogle really drove this idea home in a 2016 interview for the AAII Journal (“Six Questions With John Bogle”): “When you get those regular retirement plan statements … don’t open them. Don’t peek. And when you do peek … be sure you have a cardiologist standing by. Because you will be so amazed at how much money you’ve accumulated over 20 or 30 or 40 or 50 years that you won’t believe it. You’ll probably faint, or something worse, and there will be a doctor there to revive you.”

Though Bogle is talking about retirement accounts, this idea applies to all financial accounts, including your other savings accounts. A common behavioral finance hack is to keep your savings at a different bank than your checking account. Your savings will tempt you less if you don’t see them every time you log in to your checking account. Likewise, keeping your savings separate makes it more difficult for you to skim some off the top, so anything you need for emergencies shouldn’t be too difficult to liquidate.

Patience Pays Off

One of the most important things to keep in mind while investing is that any pain from losses you experience will be twice as strong as the pleasure you’ll get from gains. Investing takes patience, which means we’re not running at the first sign of trouble. The brain can have a hard time processing anything negative, but if you follow your rules-based investing strategy instead of your intuition, you will be rewarded for keeping your money in the stock market for the long term. As Crosby says, “The moral of the story: get a lobotomy and get rich.” 

Discussion

JOHN J M from WA posted over 2 years ago:

I was reviewing weekly and making changes quarterly, including rebalancing if needed. The result of this was that I had too much information to process that was not actionable. I am now trying monthly reviews, making changes if indicated monthly. I am also keeping a list of new investment ideas that I track performance for. That way, if the monthly review leads me to consider a replacement, I can compare what I own to what I could exchange it for in the portfolio. I am trying to rationalize my approach by synchronizing information acquisition with my trading cycle. More frequent information that is not actionable is simply noise. I need to support an action cycle, and not simply "do nothing". In this way I can separate decent market signals from the noise. I also qualify new investment ideas, excluding those that carry excess risk, because I have to be able to live with the results of any investment changes over a monthly cycle.


BARRY J from TX posted over 2 years ago:

John JM, thanks for outlining how your information-gathering plan aligns with your investing planning. The part of your process that impressed me was that you continually compare new data to existing data. The article seems to advocate that the old (1712) needlepoint “ignorance is bliss” is the path to investing success and recommends not paying attention to new information. For example, ”if you don’t look at your brokerage account constantly, you’re less likely to see your account in the red.” … “The brain can have a hard time processing anything negative “ “… “get a lobotomy and get rich.” The fact is your brain pays attention to thousands of things. It does so to keep you alive and your senses constantly alert your brain to changes in your environment that you need pay attention to so you can take timely action. For example, when I read that Daniel Crosby was a key source for this article, I researched his credentials. Checking the provenance of new information should always be part of an intelligent person’s activity, like John JM does and many other AAIIers say they do. Mr. Crosby’s recommendation to “get a lobotomy and get rich” is comical and pithy, but it can be very bad advice. Ignoring some new information because it make you “feel bad” is a very risky survival strategy that borders on the same emotional” causes behind alcoholism and addiction. This recommendation is antithetical to developing discipline, which may be the only good advice in this article. I get it. AAII hired Ms. Sus to onboard the next generations of AAII members. She has been given license to “repackage” conventional wisdom on the premises that the XYZ generations have short attention spans and prefer good news over bad. The popular phrase, “Uh yeh ... no,” pretty much sums up this bundle of behavioral quirks. They may sign up, but they will not stay. As they mature, and they will, the real world will educate them on the shortcomings an “ignorance is bliss” strategy to achieve success in a very unforgiving and “winner take all” market. Knowledge is bliss, but bliss ain’t cheap. In Ecclesiastes 1:18, Soloman, a very wise man who had many reasons to be sorrowful, says "For in much wisdom is much grief, and he who increases knowledge increases sorrow." Agreed, it is more comfortable not to know something in some instances that creates sorrow, but it is not a survival strategy for life or for investing. One example, "diversification always means always having to say you're sorry" reinforces the fact that EVERY portfolio is at best a guess (hopefully an educated and well-reasoned one) of which mixture of investments will increase market performance in future markets no one can possibly predict. But outperforming a market with a historical return of 10% in a world that also has a 3% inflation rate requires skill, not hope ... or ignorance.


ROBERT A from NC posted over 2 years ago:

I guess there are exceptions to every rule. My first three major investments were all in the same industry. I took a bath on one of them not long before it went into bankruptcy, but the other two made me wealthier than I ever thought I would be. Also, I check my portfolios several times a day--and do nothing. To me, it's like desensitization training. My feelings about market movements are powerful and all over the place, but the mental callouses I've built up by not listening to emotions have served me well. Buy and hold!


JOHN J M from WA posted over 2 years ago:

Interesting to hear these two member's perspectives. Here are a few more thoughts about those useful but dangerous market emotions: fear and greed. I keep a portion of the portfolio in lower risk fixed income investments, to match the James Cloonan advice to always hold something that can be sold in a down market. I have 13 equity/risk-on and 9 fixed income/risk-off positions of roughly equal size. So close to the 60/40 ratio. That provides the buffer in a down market, so that I can stay the course. Then I measure my results not as gains vs losses, but as my portfolio vs the market average, computed as the average of the Dow results, the S&P 500 results and the NASDAQ results, both monthly and the averages year-to-date. For example, if the Dow is up 2.00% and the S&P 500 is up 4.00% and the NASDAQ is up 6.00%, the average of the 3 is 4.00% I am set up targeting 60% of that result, so my comparison would be to 2.40% In that way, although my gain is smaller, it's matched to my threshold for performance. I also expect to decline comparatively less when markets turn negative. That is the most important objective, avoiding the full extent of market losses. That is the payoff for risk diversification: the losses are contained. Since I am living on these portfolio proceeds, that's important.


BLAINE W from WA posted over 2 years ago:

My wife and I wrote and signed a plan. I'm a chronic looker and she never looks so the compromise is that I can look all I want but WE can only make changes once a year in retirement accounts and twice a year in our taxable account; IF we both agree on the change. After 15 years this seems to be working for us


Dale C from AZ posted over 2 years ago:

I tend to check my Portfolio daily except when traveling. I find this works for me and keeps me learning and understanding what is happening in the markets. I am generally a long term investor. I do an individual written analysis every six months on each position but continue to review my positions on a regular basis which also includes maintaining my two CD Ladders and my tax exempt bond portfolio. My excuse for this is that I am a retired CPA and no longer get to watch my ex-clients screw up.


Christopher M from NJ posted over 2 years ago:

Agree with Barry above. With some ups and downs, I have created a process that cross-checks potential stocks through multiple platforms and inputs. I check my portfolio daily and after many years, do not experience the angst I had when I was younger. This year, I am beating the S&P by 4 percentage points with just 68% of the portfolio in the market. The rest is in cash earning 5% or so. Am saying this not for plaudits or praise, but to state that the success is directly attributed to daily immersion in the marketplace and trying to (sometimes successfully, sometimes not) predict where the market is heading. Admittedly, I do have the privilege of not working full-time. This allows my immersion.


BARRY J from TX posted over 2 years ago:

The May 24 "Intelligent Investor" column in the WSJ by Jason Zweig on "What Our Brains Know About Stocks—But Won’t Tell Us" focuses on the same subject as this article - gut feelings when you invest is often a terrible idea but he focused on research that helps explain why emotions can sometimes be beneficial. The link is @ https://www.wsj.com/finance/investing/what-our-brains-know-about-stocksbut-wont-tell-us-880d5d72?st=bvhr1p7un5l4pri&reflink=desktopwebshare_permalin


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