Whilst I’m a firm proponent of Modern Portfolio Theory, which is based on the empirical evidence that markets are efficient and nobody can consistently predict the stock markets, my decades of experience working as an adviser have taught me that biases can affect investor behaviour. Investing is much more than just analysing numbers — a large part of my role involves steering investors away from making emotional decisions. Failing to understand our own behavioural biases and how to overcome them in investing can have a detrimental influence on portfolio performance. Investors often deviate from logic and reason. By examining the psychological issues revealed through the study of behavioural finance, investors can more readily reach impartial decisions.
Market efficiency should not be abandoned in favour of behavioural finance. However, these eight behavioural biases speak to some fundamental issues that investors might face at different periods during their lifetimes.
Below is an extract from the European Financial Review “How Biases Affect Investor Behaviour”by Kent Baker and Victor Ricciardi which draws on some of the themes and strategies from the authors’ book “Investor Behaviour – the Psychology of Financial Planning and Investing”.
Common Behavioural Biases
- Representativeness. Representativeness results in investors labelling an investment as good or bad based on its recent performance. Consequently, they buy stocks after prices have risen expecting those increases to continue and ignore stocks when their prices are below their intrinsic values. Investors should have a clearly defined analytical process that they test and retest in order to refine and improve it over the long run.
- Regret (loss) aversion. Regret aversion describes the emotion of regret experienced after making a choice that turns out to be either a bad or inferior choice. Investors who are influenced by anticipated regret are motivated to take less risk because this lessens the potential for poor outcomes. Regret aversion can explain investor reluctance to sell “losing” investments because it gives them feedback that they have made bad decisions. Disciplined investing requires overcoming the reluctance to realise losses.
- Disposition effect. Closely related to regret aversion is the disposition effect, which refers to the tendency of selling stocks that have appreciated in price since purchase (“winners”) too early and holding on to losing stocks (“losers”) too long. The disposition effect is harmful to investors because it can increase the capital gains taxes that investors pay and can reduce returns even before taxes. Following the advice of “cut your losses and let your profits run” enables investors to engage in disciplined investment management that can generate higher returns.
- Familiarity bias. This bias occurs when investors have a preference for familiar investments despite the seemingly obvious gains from diversification. Investors display a preference for local assets with which they are more familiar (local bias) as well as portfolios tilted toward domestic securities (home bias). An implication of familiarity bias is that investors hold suboptimal portfolios. To overcome this bias, investors need to cast a wider net and expand their portfolio allocation decisions to gain wider diversification and risk reduction. Investing internationally helps to avoid familiarity bias.
- Worry. The act of worrying is an ordinary and unquestionably widespread human experience. Worry induces memories and visions of future episodes that alter an investor’s judgment about personal finances. Based on survey evidence, Ricciardi (2011) finds that a much larger percentage of responding investors associate the word “worry” with common stocks (70 percent) as compared to bonds (10 percent). More anxiety about an investment increases its perceived risk and lowers the level of risk tolerance among investors. In turn, this concern increases the likelihood that investors will not buy the security. To avoid this bias, investors should match their level of risk tolerance with an appropriate asset allocation strategy. As a quick test, if investors cannot sleep because of apprehension about their investments, they probably should have a more conservative and hence lower risk investment portfolio.
- Anchoring. Anchoring is the tendency to hold on to a belief and then apply it as a subjective reference point for making future judgments. Anchoring occurs when an individual lets a specific piece of information control his cognitive decision-making process. People often base their decisions on the first source of information to which they are exposed (e.g., an initial purchase price of a stock) and have difficulty adjusting or changing their views to new information. Many investors still anchor on the financial crisis of 2007-2008 as a bad experience. As Ricciardi (2012) notes, this results in a higher degree of worry, which can cause them to underweight equities in their portfolios because they are excessively risk and loss-averse. To avoid anchoring, investors should consider a wide range of investment choices and not focus their financial decisions on a specific reference point of information.
- Self-attribution bias. Investors who suffer from self-attribution bias tend to attribute successful outcomes to their own actions and bad outcomes to external factors. They often exhibit this bias as a means of self-protection or self-enhancement. Investors afflicted with self-attribution bias may become overconfident, which can lead to overtrading and underperformance. Keeping track of personal mistakes and successes and developing accountability mechanisms such as seeking constructive feedback from others can help investors gain awareness of self attribution bias.
- Trend-chasing bias. Investors often chase past performance in the mistaken belief that historical returns predict future investment performance. Mutual funds take advantage of investors by increasing advertising when past performance is high to attract new investors. Research evidence demonstrates that investors do not benefit, because performance typically fails to persist in the future. For example, using a sample of 1,020 domestic actively managed mutual funds, Soe and Luo? (2012) show that using past performance as a strategy, fails. For the five years ending March 2012, only about 5 percent of the funds maintained top-half performance rankings over five consecutive 12-month periods, while 6 percent were predicted to repeat by chance alone. To avoid this bias, investors should resist following the herd or jumping on the bandwagon. Although investors may feel better when investing with the crowd, such an investment strategy is unlikely to lead to superior long-term performance.
At Quadrant Group, we help clients to understand their tolerance to risk and to recognise and understand their individual behavioural biases and predispositions. We aim to provide financial peace of mind, implementing an investment plan that allows investors to feel much more confident about their financial plans and to be less likely to make common behavioural mistakes.
If you want to know more about working with a Quadrant Group wealth adviser, please get in touch.
This article does not constitute financial advice. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner to take into account your particular investment objectives, financial situation and individual needs. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections.