It’s no secret that we are our own worst enemies when it comes to investing. Often, all it takes is a “hot” stock tip, a news headline, or a prediction by some market pundit to spur investors into a flurry of action. Negative news? Time to get out of the market. Your cousin’s portfolio is up by 22%? Time to copy his investment techniques!
We see the consequences of this type of investor behavior through 25 years of research by DALBAR. DALBAR’s Quantitative Analysis of Investor Behavior study tracks investor returns and finds consistently that the average investor earns much less than market indices suggest. For example, according to DALBAR, the average investor lost 9.42% in 2018, compared to losses by the S&P 500 of only 4.38%. Why? DALBAR attributed the loss to investor behavior — avoiding market volatility by decreasing exposure, and even losing more money by being out of the market during periods of gains.
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As a financial adviser, I spend a lot of time trying to educate my clients about the wide range of emotional behaviors that can potentially sink their carefully constructed financial plans. It’s something advisers see frequently. In fact, A 2019 study with more than three hundred advisers identified evidence of at least 15 biases affecting clients’ investment decisions. Here are the top three most common blind spots advisers see in their practices:
- Recency Bias: When evaluating an investment decision, how likely are you to rely on recent news headlines to inform your choices? According to the 2019 BeFi Barometer, recency bias is the most common bias advisers see among their clients. Recency bias occurs when an investor tends to weigh recent events more heavily than earlier events. Instead of understanding that each new day brings the possibility of change, the investor concludes that what happened yesterday will happen again today and tomorrow. The consequences can include irrational decision-making, such as fleeing to cash in a volatile market, or loading up on a particular stock that has received glowing headlines.
How to avoid recency bias: Look for context in long-term trends, not just recent headlines, to provide perspective. If you have worked with your adviser to create a financial plan, stick to it. Jumping in and out of the market places you at greater risk. As David Booth of Dimensional Fund Advisors puts it, “Missing out on big growth has as much of an impact on a portfolio as losing that amount. How long does it take to make that kind of loss back? And how is someone who got out supposed to know when to get back in?”
- Loss Aversion: Would you rather win, or would you rather avoid losing? Surprisingly, investors tend to prefer avoiding losses over achieving equivalent gains. Here’s an example: Behavioral science experts Amos Tversky and Daniel Kahneman asked people to participate in a coin flip. Tversky and Kahneman explained that if the coin came up tails, participants would lose $100. However, if the coin came up heads, participants would win $200. Their experiment found that on average, participants needed to gain approximately twice what they were willing to lose before they would be willing to play the game.
Here’s how that example translates to everyday investing: Suppose you decide to move your investments to “safe harbor” accounts (think money markets and CDs) to avoid potential losses in a down market. The longer you stay in these kinds of accounts, the more you risk losing some of your purchasing power to inflation. And, back to David Booth’s point: How do you know when to reinvest in the market?
How to avoid loss aversion: Focus on your long-term goals instead of worrying about the day-to-day ups and downs of the market. You’ll sleep better and portfolio will continue to grow over time.
- Confirmation Bias: Confirmation bias occurs when we favor information that reinforces the things we already believe. It’s a common phenomenon in how we choose our news sources (think FOX vs. CNN), and it’s also common in investing. You may hold a lot of a certain stock, and continually seek reports that confirm that your decision to invest was a good one.
How to avoid confirmation bias: Always consider multiple viewpoints. If you work with an adviser, ask him or her to help you evaluate investments by including the pros and cons of any potential decision.
Advisers Can Be Biased Too
Clients aren’t the only ones prone to emotional bias. Even though most advisers are aware of the effects of bias, we are just as likely to exhibit biased behavior as the rest of the investing world. Research by SEI last year found that advisers ranked “overconfidence” and “regret avoidance” as their top weaknesses, and I’m sure other biases may surface from time to time, depending on the situation.
So, if both you and your adviser are vulnerable to emotional bias, how can you keep biases from sneaking into your investment decisions? The answer may lie within the adviser-client relationship.
In his book, Being Mortal, author and surgeon Atul Gawande describes three types of doctors. A paternalistic doctor tells patients what to do. An informative doctor goes over all of the patient’s health options, but doesn’t assist the patient in making decisions. And an interpretive doctor not only provides information, but also works collaboratively with the patient to help him or her understand and focus on making the best decision. Many financial advisers fall into one of these three camps as well. An interpretive adviser will help you sift through the incessant, confusing noise of the market and the media with the goal of serving you and your family, and because you work collaboratively, he or she should welcome your feedback. Working together, you serve as each other’s accountability partner.
Benjamin Graham, the father of value investing, provided some of the best advice when it comes to emotional biases: “By developing your discipline and courage,” he said, “you can refuse to let other people's mood swings govern your financial destiny. In the end, how your investments behave is much less important than how you behave.” Keeping your emotions in check is never easy, but it can certainly make a difference when creating wealth.
About the Author:
Wayne B. Titus III, CPA/PFS, AIFA® founded AMDG Financial and AMDG Business Advisory Services in 2002 based on his fifteen years’ experience at two large accounting firms, where he worked with Fortune 50 clients. He dove into entrepreneurship to make a bigger impact on people's lives. As a fee-only fiduciary adviser, his loyalty is to his clients: he places their interests ahead of his own or those of his firms. With assets of more than $188 million, AMDG Financial integrates tax, financial and investment strategies to help clients make financial and life transitions successful on purpose. The company's credo is, "From financial wisdom, better stewardship.” His latest book is The Entrepreneur’s Guide to Financial Well-Being (Lioncrest Publishing, March 2019). To learn more, visit amdgservices.com