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Understanding Investor Biases

Emotions and money each cloud judgment. Together, they create a perfect storm that threatens to wreak havoc on investors’ portfolios.

One of the biggest risks to investors’ wealth is their own behavior. Most people, including investment professionals, are prone to emotional and cognitive biases that lead to less-than-ideal financial decisions. By identifying subconscious biases and understanding how they can hurt a portfolio’s return, investors can develop long-term financial plans to help lessen their impact. The following are some of the most common and detrimental investor biases.

Overconfidence is one of the most prevalent emotional biases. Almost everyone, whether a teacher, a butcher, a mechanic, a doctor or a mutual fund manager, thinks he or she can beat the market by picking a few great stocks. They get their ideas from a variety of sources: brothers-in-law, customers, Internet forums, or at best (or worst) Jim Cramer or another guru in the financial entertainment industry.

Investors overestimate their own abilities while underestimating risks. The jury is still out on whether professional stock pickers can outperform index funds, but the casual investor is sure to be at a disadvantage against the professionals. Financial analysts, who have access to sophisticated research and data, spend their entire careers trying to determine the appropriate value of certain stocks. Many of these well-trained analysts focus on just one sector, for instance, comparing the merits of investing in Chevron versus ExxonMobil. It is impossible for an individual to maintain a day job and also to perform the appropriate due diligence to maintain a portfolio of individual stocks. Overconfidence frequently leaves investors with their eggs in far too few baskets, with those baskets dangerously close to one another.

Overconfidence is often the result of the cognitive bias of self-attribution. This is a form of the “fundamental attribution error,” in which individuals overemphasize their personal contributions to success and underemphasize their personal responsibility for failure. If an investor happened to buy both Pets.com and Apple in 1999, she might attribute the Pets.com loss to the market’s overall decline and the Apple gains to her stock-picking prowess.

Investments are also often subject to an individual’s familiarity bias. This bias leads people to invest most of their money in areas they feel they know best, rather than in a properly diversified portfolio. A banker may create a “diversified” portfolio of five large bank stocks; a Ford assembly line employee may invest predominantly in company stock; or a 401(k) investor may allocate his portfolio over a variety of funds that focus on the U.S. market. This bias frequently leads to portfolios without the diversification that can improve the investor’s risk-adjusted rate of return.

Loss Aversion
Some people will irrationally hold losing investments for longer than is financially advisable as a result of their loss aversion bias. If an investor makes a speculative trade and it performs poorly, frequently he will continue to hold the investment even if new developments have made the company’s prospects yet more dismal. In Economics 101, students learn about “sunk costs” — costs that have already been incurred — and that they should typically ignore such costs in decisions about future actions. Only the future potential risk and return of an investment matter. The inability to come to terms with an investment gone awry can lead investors to lose more money while hoping to recoup their original losses.

This bias can also cause investors to miss the opportunity to capture tax benefits by selling investments with losses. Realized losses on capital investments can offset first capital gains, and then up to $3,000 of ordinary income per year. By using capital losses to offset ordinary income or future capital gains, investors can reduce their tax liabilities.

Aversion to selling investments at a loss can also result from an anchoring bias. Investors may become “anchored” to the original purchase price of an investment. If an investor paid $1 million for his home during the peak of the frothy market in early 2007, he may insist that what he paid is the home’s true value, despite comparable homes currently selling for $700,000. This inability to adjust to the new reality may disrupt the investor’s life should he need to sell the property, for example, to relocate for a better job.

Following The Herd
Another common investor bias is following the herd. When the financial media and Main Street are bullish, many investors will happily put additional funds in stocks, regardless of how high prices soar. However, when stocks trend lower, many individuals will not invest until the market has shown signs of recovery. As a result, they are unable to purchase stocks when they are most heavily discounted.

Baron Rothschild, Bernard Baruch, John D. Rockefeller and, most recently, Warren Buffett have all been credited with the saying that one should “buy when there’s blood in the streets.” Following the herd often leads people to come late to the party and buy at the top of the market.

As an example, gold prices more than tripled in the past three years, from around $569 an ounce to more than $1,800 an ounce at this summer’s peak levels, yet people still eagerly invested in gold as they heard of others’ past success. Given that the majority of gold is used for investment or speculation rather than for industrial purposes, its price is highly arbitrary and subject to wild swings based on investors’ changing sentiments.

Often, following the herd is also a result of the recency bias. The return that investors earn from mutual funds, known as the investor return, is typically lower than the fund’s overall return. This is not because of fees, but rather the timing of when investors allocate money to specific funds. Funds typically experience greater inflows of new investment following periods of good performance. According to a study by DALBAR Inc., the average investor’s returns lagged those of the S&P 500 index by 6.48 percent per year for the 20 years prior to 2008. The tendency to chase performance can seriously harm an investor’s portfolio.

Addressing Investor Biases

The first step to solving a problem is acknowledging that it exists. After identifying their biases, investors should seek to lessen their effect. Regardless of whether they are working with financial advisers or managing their own portfolios, the best way to do so is to create a plan and stick to it. An investment policy statement puts forth a prudent philosophy for a given investor and describes the types of investments, investment management procedures and long-term goals that will define the portfolio.

The principal reason for developing a written long-term investment policy is to prevent investors from making short-term, haphazard decisions about their portfolios during times of economic stress or euphoria, which could undermine their long-term plans.

The development of an investment policy follows the basic approach underlying all financial planning: assessing the investor’s financial condition, setting goals, developing a strategy to meet those goals, implementing the strategy, regularly reviewing the results and adjusting as circumstances dictate. Using an investment policy encourages investors to become more disciplined and systematic, which improves the odds of achieving their financial goals.

Investment management procedures might include setting a long-term asset allocation and rebalancing the portfolio when allocations deviate from their targets. This technique helps investors systematically sell assets that have performed relatively well and reinvest the proceeds in assets that have underperformed. Rebalancing can help maintain the appropriate risk level in the portfolio and improve long-term returns.

Selecting the appropriate asset allocation can also help investors weather turbulent markets. While a portfolio with 100 percent stocks may be appropriate for one investor, another may be uncomfortable with even a 50 percent allocation to stocks. Palisades Hudson recommends that, at all times, investors set aside any assets that they will need to withdraw from their portfolios within five years in short-term, highly liquid investments, such as short-term bond funds or money market funds. The appropriate asset allocation in combination with this short-term reserve should provide investors with more confidence to stick to their long-term plans.

While not essential, a financial adviser can add a layer of protection by ensuring that an investor adheres to his policy and selects the appropriate asset allocation. An adviser can also provide moral support and coaching, which will also improve an investor’s confidence in her long-term plan.

Thinking Ahead

We all bring our natural biases into the investment process. Though we cannot eliminate these biases, we can recognize them and respond in ways that help us avoid destructive and self-defeating behavior.

Planning and discipline are the keys. Investors should think critically about their investment processes rather than letting the subconscious drive their actions. Adhering to a long-term investment plan will prevent biases from influencing investor behavior, and should help protect investors from avoidable mistakes.

Senior Client Service Manager Benjamin C. Sullivan, who is based in our Austin, Texas office, contributed several chapters to our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 13, “Federal Income Tax,” and Chapter 16, “Investment Psychology.” He was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.