You have now completed the chapters on the mechanics of investing basics, and behavioral mistakes have been mentioned several times. If you wanted to apply the term ‘elephant in the room’ to the reason investors lose out on potential returns, behavioral errors would be it.
Behavioral finance as it’s called is a relatively new field. It attempts to better understand and explain how emotions and cognitive errors influence investors and the decision-making process. And while the researchers are beginning to understand what investors do to hurt returns, the investors themselves are quite oblivious to the mistakes they make.
As Warren Buffet has said, investing is simple, but not easy. Why? Because the cognitive skills needed to invest properly are in direct conflict to how we have learned to respond to familiar situations. We approach investing with those ideas learned in the family environment and in our own experiences unrelated to investing. Then, when faced with a new challenge, we apply those biases already ingrained in our memory. For instance, we are taught to be the best, don’t settle for average, you can do it if you really try. New investors are overwhelmed with information and endless recommendations, forecasts, insider tips (secret stuff) and excitement! These are bad stimuli for the investment brain, but to sort things out we fall back on things we know, although they may be very inappropriate when applied to investing. Furthermore, we can rationalize almost anything when we subconsciously want to choose one decision over another.
While the investment method discussed in this primer tends to keep behavioral mistakes minimized, you must be aware of the natural temptation to do the wrong thing. Don’t get emotionally involved. Good investing should be about as exciting as watching grass grow. And to go a bit further with this analogy, think of investing as a plow horse cultivating a field, and not a race horse.
Here are the most common behavioral errors and how they create bad decisions
1. Overconfidence. Overconfidence is perhaps the most common behavioral mistake, and while it’s pretty easy to spot by someone who is overconfident, it’s almost impossible for the afflicted investor to recognize it in himself. Ask any group of active investors trying to outperform average market returns and they will tell you they are indeed better than average. Why else would they attempt to beat the market in the first place? To make matters worse, overconfident investors are subject to something called the Dunning-Kruger effect. The Dunning–Kruger effect is a bias in which an unskilled person makes poor decisions and reaches erroneous conclusions, but their incompetence denies them the ability to realize their own mistakes. Overconfidence leads investors to frequent portfolio changes and higher risk taking due to overestimating knowledge and ability while underestimating risk. Ultimately, the results are higher costs and lower returns. Professional stock analysts and fund managers are not immune to this problem either.
Overconfidence is the most common problem, but it is also the most difficult to overcome. Many investors believe that they are adequately competent when they learn to speak the language of Wall Street as well as the pundits on TV, or they know the fundamentals of choosing stocks or mutual funds. What they fail to realize is there are millions of investors with the same knowledge and simply knowing facts is not knowledge, and knowledge is not wisdom. Overconfidence cannot be eliminated unless the investor takes a disciplined, neutral approach to the investing process. The investor must also realize that beating the market is not an easy task that can be accomplished with a little extra work. There are many factors involved beyond the investor’s control.
For an average investor, and that is most of us not formally schooled in finance and economics and without the Wall Street electronic equipment and constant research, it is best to not get caught up in the idea that we are better than average. Average on Wall Street is a very high water line and you are most likely underwater. If you believe you have the ability to choose winning stocks or fund managers, reading up on stock market history might provide a more sobering picture.
2. Loss Aversion and Risk Aversion. Loss aversion refers to the tendency for people to strongly prefer avoiding losses over acquiring gains. Loss aversion has several implications, but the fact is investors experience more pain over losses than they feel pleasure over the same amount of gain. In one classic experiment, players were asked how much they would need to win in a coin toss game before they would play when the other player won $100 if the coin turned up heads. The logical answer, of course would be $100, but the actual answer players gave was close to $200. They weren’t willing to lose $100 until the a win paid almost double.
Investors who experience loss aversion will focus obsessively on one investment that’s losing money, even if the rest of their portfolio is in the black. They are also more likely to sell winning funds in an effort to “take some profits,” while at the same time not wanting to sell losers. Loss aversion naturally leads to risk aversion. Risk aversion is the reluctance of a person to accept an investment with an uncertain payoff (stock risk) rather than an investment with a more certain, but possibly lower, expected payoff (bonds or bank account.).
3. Recency Bias and Information Overload . Recency bias is the tendency to weight recent market action as the basis for intended long term decisions. But of course, investors who use recent performance never make any decisions that last very long. Recency bias leads to buying high, selling low, and excessive, irrational portfolio changes. Information overload is somewhat similar to recency bias. The danger of too much information is we believe we can absorb it all, but the memory is selective to information we perceive as supporting our position.
In another simulation experiment done by pioneers Richard Thaler, Amos Tversky, Danial Kahneman and Alan Schwartz, two groups of subjects were given identical portfolios consisting of one stock fund and one bond fund to manage. One group was given updated information on the portfolio and the stock market monthly and the other was given information only annually. The groups could only make portfolio changes at the time the information was provided. The results showed that the group who received information monthly made more portfolio adjustments; however, at the end of the simulation time, this group underperformed the less active group by a remarkable 50%. When it comes to Wall street information, less is better.
Recency bias and performance chasing are made by investors who are either unaware of this common behavioral mistake, or they lack discipline and a good long-term investing plan.
4. Fear of Regret. Regret comes from the emotional reaction people get when they conclude they’ve made an error in judgment. Sometimes the decision is wrong, but it may have also have been correct, but the outcome was negative. Because investors don’t separate correct process decisions from outcomes, the feedback leads to further errors. Mistakes are treated as major failures, and they reduce confidence and freeze rational thought. Fear comes into the picture the next time a decision has to be made. Investors do lnot like to regret what they’ve done; therefore, they may be hesitant to make the next required decision and they may also drift from the correct decision making process and make a worse decision. Investors can become paralyzed if they focus on an anticipated outcome rather than following their established process.
Again, awareness is much of the battle. Investors need to establish a plan that is logical and uncomplicated and stick to it. Yes, occasionally a result may not turn out as hoped, but an undesirable outcome should be blamed on a good decision making process, and there should be no regret. In the long run, the plan will be rewarded.
5. Anchoring. When new or unfamiliar situations are presented, people attempt to relate or “anchor” the new information to a familiar reference point even though it may have no relationship to the new situation. This tendency may cause investors to base decisions on irrelevant past experience or an illogical reference point. As an example, an investor may make a decision to buy more of a stock which has dropped in price based on previous high values without knowing any new information that may have triggered the drop. The investor anchored on the previous high value.
Overcoming the anchoring problem is not too difficult. The caution flag should go up when a conclusion is made without much examination or thought about new data simply because it seems to fit a previous conclusion. The proper approach is to explore the facts from a different perspective, or to seek input from other investors who don’t always agree with you.
6. Confirmation or Comfort Bias. This is a tendency for investors to form a consenting opinion of first impressions that align with preconceived ideas because information is selectively favored. Confirmation bias also leads investors to look for and file additional information that supports their beliefs. Overcoming confirmation bias requires the investor to actively seek and discuss and weigh opposing viewpoints.
Procrastination is very common and it leads to investors neglecting to manage their portfolios properly. It may cause them to not rebalance when necessary or to simply not pay attention to the performance of actively managed funds in their portfolio. Procrastinators may end up with a very different portfolio than they created and they may be caught off-guard in sudden market changes.
The six listed behavioral mistakes are major ones, but certainly not the only ones. Have a look at this list and review it once in awhile as a reminder:
Behavioral Issues and the Bottom Line
Studies have shown that behavioral mistakes reduce the return on investments that investors actually receive by 10% to as much as 75%. So what do investors need to do to pocket more of the returns? One word: discipline. Don’t focus on becoming too smart; instead focus on avoiding foolish behavior and you’ll be successful.