The way to make money in investments is simple, right? Buy low, sell high. Seems like such a straightforward concept.

If this is true then why do so many investors do the exact opposite? It's been said that stocks seem to be about the only thing in the world people don't want to buy when they're on sale. A powerful example of this is found by evaluating the performance of the stock market versus that of the “average investor.” According to a Dalbar Inc. study, over the last 20 years (1998-2017) the S&P 500 stock index had an average annual return of 7.2 percent. By contrast, the average investor generated a meager 2.6 percent average annual return. To put some numbers around that, a $10,000 investment in the S&P 500 index would've been worth $40,169 in 20 years whereas the average investor's $10,000 would have only grown to $16,709.

It turns out that there are some really good reasons for this poor performance by the average investor. We humans come hard-wired with some innate biases that work against us when we don our investor hat. Over the last few decades, a field of study called “behavioral finance” or “behavioral economics” has emerged to help explain why we make the decisions (and often mistakes) that we do when it comes to our money. Some of the professors who pioneered these studies have won a few Nobel prizes, so it's probably worth taking note.

Let's explore a couple of these concepts and see how we can use our awareness of these biases to help us make better decisions.

Recency Bias

Think back to the last time you had a really tough week at the office. Your schedule was jam-packed, a few meetings didn't live up to your expectations and you had a difficult conversation with a client or two. Remember how it felt in the middle of that tough stretch? My guess is it felt like it was never going to change. You probably even felt somewhat helpless at times and had a hard time imagining things getting better. That is recency bias—our tendency to believe that things are going to continue to be the way they have recently been.

This bias can cause significant problems when it comes to investing. When things are going particularly poorly, or particularly well in your portfolio, it's tempting to believe that the recent trend will continue. This bias can easily lead investors to do the exact opposite of what they should do, and they end up buying high and selling low. As stocks are trending upward (and getting more expensive) investors want to buy more because it feels better to buy amid positive momentum. The same is true on the downside. If the market has been mired in an extended downturn, investors feel that the downward spiral must continue, so they capitulate and get out of the market at the worst possible time, thus locking in their losses.

To combat this bias, it helps to zoom out and look at the big, long-term picture. One way to do that is to study a chart of the stock market's historical returns. If you look at any single quarter or year it's essentially a coin flip as to whether the market will be up or down. However, if you zoom out and look at a rolling 10-year average of returns, you see that you are very likely to enjoy positive returns over the long haul and the ride looks much smoother. This longer-term perspective will help keep you in your seat when things get rocky and prevent you from getting greedy when things are going well.

Loss Aversion

Have you ever reached into your pocket and found an unexpected $20 bill? It feels good, right? Now, how about when you think you have $20 in your pocket, you reach in to get it and nothing's there? You search all your other pockets, your wallet, everywhere, but it's gone. How does that feel?

Research by professors Amos Tversky and Daniel Kahneman would suggest the feeling that comes over you when you lose your money is about twice as powerful as when you experience a gain. In other words, the pain of losing far outweighs the joy of winning. I've even heard NFL players talk about how losing that big game hurt much worse than the joy they felt when they won it all.

The implications of this bias in investing are significant. If you've invested for long enough, you have no doubt had some lemons in your portfolio. Let's say you read about a company that seemed like a great business, so you decided to buy its stock. Think back to how you reacted as the investment started to go south. Were you quick to unload it, cutting your losses and moving on to another investment opportunity? If you're like most people the answer is no. In order to avoid the sting of locking in the loss, you hold on in the hopes that it will turn around and you will at least get back to breakeven. Over time, the investment continues its decline and you're still holding on.

Instead, try to think about each investment as an opportunity. It's impossible for every opportunity to go the way you'd like. When an investment proves that it's not as good as you'd hoped, try to think of the decision to sell not as a loss but as an opportunity to move on to something potentially better. This more optimistic, positive way of thinking can help you avoid getting caught in the loss aversion trap.

Perhaps the greatest investor of our time, Warren Buffet has been quoted as saying, “Investing is simple, but not easy.” Part of the reason investing is not easy is because of the way we are wired. Hopefully with a better understanding of our humanness and the biases that can work against us we can become a little more like Warren.

Important Disclosure: Investments involve risk and past performance may not be indicative of future results. Balasa Dinverno Foltz LLC (BDF) investment and wealth management strategy recommendations may not be profitable, suitable or equal historical performance. BDF's current written disclosure statement discussing advisory services and fees is available for review at www.BDFLLC.com or upon request.

Justin Peacock is an owner and wealth manager at BDF, a fee-only wealth management firm based near Chicago. Peacock, who leads the firm's attorney practice group, can be reached at [email protected].