By: Adam S. Drake, CFA
“Focus on what you can control, ignore what you can’t.”
Sir Isaac Newton once said, “I can calculate the motion of heavenly bodies but not the madness of people.” During the 20th century, behavioral economics emerged as an area of study that attempted to understand how social, cognitive and emotional factors affect economic decisions. The purpose of this article is to make readers aware of common traps investors fall into so that they can be better prepared to avoid them. The information herein is based on a presentation by Dimension Fund Advisors, and used with their permission.
Behavioral biases come into play in many routine decisions, but these biases can be detrimental when trying to make financial decisions. What are these biases, how do they affect decision making, and how can investors regain control?
First, let’s revisit a basic fact: risk and return are related. Financial losses are processed in the same areas of the brain that respond to mortal danger. Investors who react emotionally to losses that have already occurred tend to avoid risk after the loss. Investors also tend to increase their risk exposure after profits have been made, assuming that success will continue. Although we know that more risk translates to more expected return, investors reduce risk when risk and expected return are their highest and increase risk when risk and expected return are their lowest. In short, investors tend to buy high and sell low. According to Dalbar, the average investor lost -41.63% in 2008 when the S&P 500 lost 37.72%. Why? Investors buy into strong performance and sell into weak performance. This tells us that investor behavior is more important than fund performance alone.
Here are several examples of common behavioral biases:
Overconfidence. Confidence is a good attribute in most areas of life, but overconfidence can be destructive to our wealth. Investor survey results consistently show that well over half of investors think that their portfolio’s return will be higher than the markets. Of course, 50% of us must be above average and 50% must be below average. Overconfidence in what investors know, or what they think they know, seldom leads to outsized returns.
Familiarity. This bias pertains to only holding investments which we are familiar with, such as stock in the company we work for or mutual funds invested in U.S. stocks. While it certainly is important to understand what you are invested in, ignoring the whole picture can mean missed opportunities. Remember, the market does not reward investors for familiarity or loyalty to an investment.
Regret avoidance. “Once bitten, twice shy.” We tend to avoid repeating behavior that has caused past pain. You should avoid bad decisions, like not properly diversifying, but realize you can’t avoid bad outcomes, like the market going down. The best way to avoid regret is to stick with a plan or hire an advisor that can keep you on track.
Extrapolation. This occurs when we base decisions on selected facts and ignore data that is contrary to our biased opinion. In other words, we often assume that a recent trend will continue into the future. The truth is that future returns are based on news that hasn’t come out yet, and past returns are based on news that’s already reported.
So, how can investors avoid these traps?
First, don’t mix speculation with gambling. If you want excitement, go to Las Vegas. Buy and hold investing may seem dull, but investors should accept the ups and downs of the market knowing the odds favor the investor. The house, as in Vegas, has the advantage against the speculator.
Second, the only path to higher returns is to take higher risk. If anyone tells you otherwise, be skeptical. You can read the WSJ cover to cover before 7:00 AM, but you still don’t know more than the market.
Finally, maintain a disciplined approach and partner with a good steward of your capital. Focus on what you can control: expenses, diversification, taxes, and discipline. Ignore what you can’t control: picking winning stocks, picking winning managers, timing the market, and the financial press.
Ken Karr, CFP and Adam Drake, CFA are partners at Highland Investment Advisors, LLC, a registered investment advisor (RIA) providing investment management and financial planning since 2006. Based in Milwaukee, WI, the firm serves clients in eight states and manages investments for individuals, retirement plans, not-for-profits, and independent investment advisors. They can be reached at 414-755-2309 or info@highlandinvestmentadvisors.com
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