7 mental biases that could impact how you invest

Fall, curiously, has never been viewed as a great season for investing.

Historically, the stock market tends to see a decline in September, and it's generally considered the worst month performance-wise for stocks. Meanwhile, the biggest stock market crashes — Black Tuesday in 1929 and Black Monday in 1987 — both took place in October.

Even pundits have a hard time pinpointing the market forces that can possibly explain why 'tis the season for skittish investors.

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But there is one thing that seems indisputable: There's no shortage of brain forces at work.

Maybe the end of summer makes you feel less relaxed, or perhaps the anticipation of Halloween is unearthing hidden fears about your investing strategy. Whatever the case, the psychology of investing says you have naturally held cognitive biases that could affect the way you make decisions about your portfolio … whether you realize it or not.

To help you nip those tendencies in the bud, we rounded up some of the most common tricks your brain plays on you — from the recency bias to the negativity bias — along with some strategies for tackling those mental blocks.

1. Recency bias

How it tricks us: Think of the recency bias as your short-term memory winning out over your long-term one. Essentially, it's the tendency to believe that what happened in the most recent past will continue to happen in the future. For example, if you got "heads" several times in a row in a coin toss, a bettor may be inclined to think it'll land heads again — even though the odds, logically, are 50-50 with each toss.

In investing, recency bias happens when people choose investments for their portfolio based on the most recent top performers, a phenomenon also known as "chasing returns," says David Blaylock, a CFP® with LearnVest Planning Services. So even if you know past results don't predict future performance, it's the most recent run-up that tends to stay in your mind.

How to outsmart it: As with your retirement account, you're likely investing for the long run, so it makes sense to build your portfolio with a longer timeframe in mind. "I always encourage clients not to pick top performers purely based on the last three months," Blaylock says. "I suggest they look at top performers from the last 10 years — it's that longer track record that you should be looking for."

Also remember that generally speaking, what goes up will eventually go down when it comes to the markets. So getting in on the market when it's riding high, and pulling out when it drops, potentially leaves you worse off than if you had stayed the course. In fact, research shows that short-term trading within any given year could mean you gain up to 50 percent or lose up to 40 percent of your money. Twenty-year returns, however, have never fallen into the red.

2. Sunk-cost fallacy

How it tricks us: Ever finished reading a book you knew was awful 50 pages in, or watched a three-hour movie even though you began cringing in the first 15 minutes? Then you may have fallen victim to the sunk-cost fallacy.

This is when you continue to put time, energy, or money into something simply because you've already made an investment in it — and refuse to cut your losses and acknowledge that you can't get back those "sunk costs."

When it comes to your portfolio, "it's the whole 'throwing good money after bad' thing, and I've seen it many times," Blaylock says. "For example, someone purchases a stock because the person really believes in the story behind the stock, and will use that to justify putting more money into the stock — even though the performance just isn't there."

How to outsmart it: The thinking behind sunk-cost fallacy is similar to another cognitive bias called loss aversion that you often find in the lexicon of the psychology of investing. This is when people try to avoid losses because they feel too painful. "Selling a stock and losing money is twice as painful as the pleasure of selling a winning stock and gaining money," says Mary Gresham, an Atlanta-based financial psychologist.

However, any investment in your portfolio that is not ultimately going to help you should probably be offloaded. So tell yourself that whatever money you're putting into it now is blocking you from another, potentially better opportunity.

Plus, cutting your losses could help you decrease your tax bill: You can use capital losses to offset capital gains, and still deduct up to $3,000 of losses from earned income on your tax return. "If you reframe in this way, as 'tax loss harvesting,' it becomes more manageable, more palatable," Gresham says.

3. Overconfidence effect

How it tricks us: There's nothing wrong with a little self-confidence. There is, however, something wrong if it distorts our reality — say, like when your mom said you did great in the talent show, even though you're tone deaf. But it left you convinced that you were a star-in-the-making.

That's what happens in the overconfidence effect: We tend to overestimate our own abilities, thinking we know more than we actually do. You see this trait often in people who believe they have some sort of secret sauce for outsmarting Wall Street.

"There are professional money managers who do this all day, every day, who can't beat the market," Blaylock says. "There is no silver bullet." In fact, only a quarter of professional fund managers outperformed the market indexes over the last 10 years, according to research from NerdWallet.com.

How to outsmart it: Leave the day trading to others and consider opting for passively managed investments with low expense ratios, like index funds that track a stock market index, rather than relying on a person's judgment calls.

People who are prone to overconfidence should also do a gut check on their risk tolerance because they may find that they're more scared of the possibility of failure than they realize. "Generally, the person who's overconfident only sees a positive outcome, so I ask them to [do an exercise] and assume that the investment doesn't work out and they lose it all," Gresham says. "What do they see as the impact on their life, on their relationships?"

And there's one more thing to consider: A well-known study in the Journal of Finance says that overconfident investors also tend to trade more frequently — and every trade means you're paying more fees that could eat into your returns.

4. Confirmation bias

How it tricks us: It's a basic human flaw: We like to think we're always right, and will go to great lengths to seek out information to uphold our preconceived notions. For instance, one legendary Ohio State study surveyed people on their political views, and then let participants browse through an online forum with various opinion pieces. One take-away? The researchers found that people spent 36 percent more time reading an essay if it supported their personal beliefs.

The problem with confirmation bias is that when we refuse to take in conflicting information, we filter out important data that could help us make more informed decisions. For example, you may get a "hot tip" about a company and focus on all the good news you read ("It's got a patent on a great idea!"), while ignoring the bad ("Revenue is way down!").

On the flip side, Gresham often sees this bias also feeding into people's deep-seated fears over investing in the stock market. "So when they have friends who lose money or they see the market tanking, it confirms that [investing] is too dangerous," she explains.

How to outsmart it: Since being objective can be hard on your own, seek out a second opinion from someone you trust — like a financial planner — who can give you a well-informed point of view and play devil's advocate.

Of course, just looking at the facts won't necessarily change a truly deep-seated belief, because the nature of confirmation bias is that you'll try to find a way to rationalize conflicting evidence. So let yourself be open to dipping a toe into experiencing the other side, especially if you're the seeing-is-believing type.

"When I work with people who are afraid of investing, I get them to make a very small investment first so that they take tiny bits of risk," Gresham says. "That might mean something like setting up a $100 automatic monthly deposit into an investment account. Then, in a year, we'll take a look to see how they feel about it."

5. Status quo bias

How it tricks us: "Stick with what you know" isn't always bad advice. After all, it may be what led you to find a fulfilling career or make good business decisions.

But the trouble with the status quo bias is that it also discourages you from leaving your comfort zone — which could mean potentially missing out on a world of other opportunities.

If your portfolio happens to be filled only with funds holding blue-chip stocks because those are the companies you're familiar with, or you only invest in U.S. investments because you live in America, then you may be succumbing to the status quo bias.

How to outsmart it: In order to overcome status quo bias, you need to understand the need for diversification in order to spread out risk. "One key to investing success is owning some portion of everything, or else you're setting yourself up for big losses if one part of your portfolio goes down," Blaylock says.

There are many ways to diversify, he adds, including mixing up your investments by asset class (i.e., stocks and bonds); introducing both large- and small-cap companies; adding international stocks and emerging markets to your mix; and even owning some alternative investments, like real estate or artwork.

And here's another sneaky way this bias gets you: sticking with the default investment option in your retirement account, instead of proactively selecting one that may be better suited for your situation. So make sure you do the research and choose one that fits your overall goals.

6. Bandwagon effect

How it tricks us: Let's face it: There are times when we go along with the crowd, even if the popular choice differs from our personal understanding. You know, like when you wait in line for the iPhone 6, even though you don't really need a new phone.

The bandwagon effect "is even more prevalent now [in investing] because we have so many avenues for information," Blaylock says. "So whatever company people think is hot is what's getting pushed, and people are scared they're going to miss out."

Blaylock points to the recent IPO of Chinese e-commerce company Alibaba, which generated a great deal of buzz. "I'm sure brokers were receiving calls from investors saying, 'I want to buy that,' " he says. "But if you were to ask them what the company actually did, most of them would probably say, 'I don't know.' "

How to outsmart it: Tune out the noise. In fact, if you're jumping on an investing bandwagon, you might be contributing to bigger problems.

Some market watchers blame the bandwagon effect for the big downward slide of some non-stock assets in 2008. Because of the equity downturn, many investors followed each other into the same alternative investments meant to serve as a hedge against stock volatility — but all that movement actually helped push those investments down too.

Your portfolio decisions should be based on research, your individual situation, your current asset mix, your investing timeline, and your risk tolerance, Blaylock says. If you don't truly understand what you're putting your money into, or if the investment isn't a good fit for your portfolio, brush off that peer pressure.

7. Negativity bias

How it tricks us: We all hate hearing bad news. Yet, for some reason, we tend to give more credence to it than good news, which is what the negativity bias is all about.

"That's why you see markets react so quickly on bad news," Blaylock says. "But when good news happens, you just hear, 'Well, the market may go up.' A lot of times, the reaction to negative news is just overreaction."

How to outsmart it: Stick to your game plan. If you reacted to every piece of bad news by selling off your investments, your returns would likely suffer.

For instance, 401(k) participants who resisted the temptation to take their money out of the market after the 2008 recession have seen the largest uptick in their retirement account balances since the downturn — with about three quarters of that growth coming from run-ups in the market, according to a Fidelity survey released earlier this year.

Translation: Remember that you're in it for the long haul. Focus on the long-term performance of your investments, limit how much attention you pay to fear-mongering media reports, and "remind yourself that nobody can predict the market," Gresham says. "It's inherently unpredictable and too complex."

This story was originally published on LearnVest. LearnVest is a program for your money. Read their stories and use their tools at LearnVest.com.

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