Overly Confident Investors May Take the Biggest Falls

Investors—especially those affected by short-term trends—are understandably rattled by recent stock market dips. But it turns out some people may be more likely to make investment mistakes during a down market, according to a personal financial planning expert who says that overconfidence tops the list. Other research shows that a substantial percentage of advisers concentrate efforts on supporting their clients through staying the course in rocky markets. 

Now is an important time for investors to remember that many mistakes can be made in this economic environment, says a personal financial planning expert from the University of Missouri. In a study published in The Journal of Personal Finance, Rui Yao, an associate professor of personal financial planning, has identified several risk factors for people who are more likely to make investment mistakes during a down market.

Yao analyzed data from the 2008 FPA-Ameriprise Financial Value of Financial Planning Research Study. That study included data about people who made a common investment mistake: moving their financial assets into a cash position during a down market without income interruptions or increased spending needs.

Most commonly, investors sell off stocks and place the cash in a bank account until the market recovers, according to “Factors Related to Making Investment Mistakes in a Down Market.” Men, Asian Americans, wealthy investors, people who are overconfident in their knowledge of the stock market and people who are loss-averse are more likely to panic and sell on the dip, Yao finds.

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“Asian Americans often move to cash positions during down markets because, culturally, they are much more likely to trade on the stock market more frequently and take a short-term investment approach as opposed to a more rational long-term approach,” Yao says. “However, market timing and frequent trading rarely pay off.”

Another driver of investment mistakes is overconfidence, Yao says. “If a person has too much confidence in the market or in their own abilities as an investor, they are much more likely to sell low, which is illogical, but common,” she explains.

These findings can help advisers forecast which of their clients may be at risk for making investment mistakes. Yao recommends observing how clients react during a down market. Do they appear overconfident or fearful of losing money? These reactions can help advisers guide their clients through challenging times, teaching them to better understand market movements and to overcome mental biases. This way, they can lessen their chances of making investment mistakes.

Once the market bounces back and investors view their portfolios in a more positive light, advisers should create a plan with guidelines about what to do if and when the market takes another dive. Research shows that retirees and pre-retirees who work with a financial adviser on a plan are more confident about their retirement income. 

“During a down market, every mistake an investor makes is magnified,” Yao says. “If financial planners can identify those who are more at risk to make these mistakes, they can more effectively work with the investors beforehand to help prevent them from making such mistakes.”

Yao’s previous research examined opportunities for advisers to educate plan participants about investing during a tough economy.