It is no secret that the way investors think and feel affects the way they behave when making investment decisions. In fact, there is an entire field of research devoted to why investors make emotional or irrational decisions called Behavioral Finance. Psychology research has documented a range of biases that shows all the ways people will fail to invest rationally even when it contradicts all available information.
As investment advisors we often act as behavioral coaches, helping to manage the financial emotions of our clients. Biases can affect all types of decision making but can have negative repercussions when they are applied to money and investing. These are some of the most common biases we have encountered and can be damaging to an investment portfolio.
Familiarity Bias is exactly what it sounds like. Investors prefer to stick with what is familiar when there may be many unfamiliar choices which have better prospects. The tendency to stick with what you know and avoid what you don’t may be harmless in everyday life, but it can wreak havoc on an investment portfolio. This is common for investors who hold substantial amounts of their employer stock in a 401(k). While the employee might be perceiving the stock as “safe” because they have conviction in the company they work for, they are exposing themselves to significant company risk in what is probably their largest retirement account.
Anchoring happens when investors cannot integrate new information into their thinking because they are too “anchored” to an existing viewpoint. Any new information provided will be devalued, especially if it contradicts a previous opinion. When investors devalue new information, they tend to underreact to changes or news and are less likely to act, even when it is in their best interest.
Loss Aversion implies that a loss is twice as painful as the pleasure received from an equal gain. Whether it’s a loss in the stock market or a championship game, most of us experience the pain of loss early on. You may ask how it can be rational for a loss to be the better choice. The answer is in the opportunity cost. Take for example an investor who buys stock for $100 per share. After six months, the stock price has fallen to $75 per share. If the investor decides not to sell the stock to avoid realizing the loss, he may pass up another stock with better earnings potential. This decision creates an opportunity cost. The opportunity cost is likely greater than the benefit of holding the original stock, but most investors will do anything to avoid taking the loss.
Ambiguity Aversion is when investors prefer risks with known probabilities over risks with unknown probabilities. Avoiding ambiguity can lead to discounting opportunities that carry greater uncertainty in favor of “sure things”. This bias about aversion to ambiguity explains why many 401(k) participants will gravitate to the U.S.-only mutual funds in their retirement plan as opposed to diversifying internationally.
Recency Bias is when an investor will overweight what happened recently and consequently extrapolate it into the future. An example of this is when an investor will base their market expectations on how good or bad the market has been performing recently. This is a dangerous trap to fall into as it can lead to buying only the outperforming asset classes resulting in a lack of diversification. During the Financial Crisis many investors suffered severe losses and consequently abandoned the stock market because they were mentally extrapolating losses into the future. During the five years following the market bottom in March 2009, a hypothetical diversified portfolio of stocks and bonds would have returned 99.7% if the person had stayed invested.
So how do you become a better investor and overcome some of these behavioral biases that may be impacting your financial decisions?
Have a financial plan. A well thought out plan and a diversified portfolio will help you focus on your long-term goals. As your financial advisor we can help take the emotion out of investing.
Get to know yourself as an investor. Become more aware of how your emotions can influence financial decisions.
Avoid panic selling. Stay invested during times of market volatility and uncertainty.
 A diversified growth portfolio of 49% U.S. stocks, 21% international stocks, 25% bonds, and 5% short-term investments. Historical monthly performance from January 2008 through February 2014 from Morningstar/Ibbotson Associates; stocks are represented by the S&P500 and SCI EAFE Indexes, bonds are represented by the Barclays US Intermediate Government Treasury Bond Index, and short-term investments are represented by U.S. 30-day T-bills.