Understanding Investor Biases




Emotions and money each cloud judgment. Together, they create a perfect storm that threatens to wreak havoc on investors' portfolios.
One of the primary risks to investors' wealth is their behaviour. Most people, including investment professionals, are susceptible to emotional and cognitive biases that lead to less-than-ideal financial decisions. By identifying subconscious biases and understanding how you can hurt a portfolio's return, investors can develop long-term financial plans to help lessen their impact. These are mainly some of the ordinary and detrimental investor biases.

Overconfidence
Overconfidence is one of the widespread prevalent emotional biases. Almost everyone thinks they might beat the market by picking a few individual stocks, whether a teacher, a butcher, a mechanic, a doctor or a mutual fund manager. They get their ideas from various sources: brothers-in-law, customers, Internet forums, and at least (or worst) Jim Cramer or another guru in the financial entertainment industry.
Investors overestimate their abilities while underestimating risks. The jury is still out on whether professional stock pickers can outperform index funds, but the casual investor will be at a disadvantage against the professionals. Financial analysts, who can access sophisticated research and data, spend their entire careers trying to discover the appropriate value of specific stocks. Several well-trained analysts focus on just one sector, for instance, comparing the merits of investing in Chevron versus ExxonMobil. An individual can't maintain a day job to perform the appropriate due diligence to maintain a portfolio of individual stocks. Overconfidence frequently leaves investors with their eggs in far too few baskets, with those baskets dangerously close to one another.

Self-Attribution
Overconfidence is often the result of the cognitive bias of self-attribution. This is a type of "fundamental attribution error," in which individuals overemphasize their contributions to success and underemphasize their responsibility for failure. For example, if an investor happened to buy both Pets.com and Apple in 1999, she might attribute the Pets.com loss to the market's overall decline and the Apple gains to her stock-picking prowess.

Familiarity
Investments are also often subject to an individual's familiarity bias. This bias leads people to invest most of their money in areas they know best rather than in a properly diversified portfolio. For example, a banker may create a "diversified" portfolio of five large bank stocks; a Ford assembly line employee may invest predominantly in company stock, or a 401(k) investor may allocate his portfolio over various funds that concentrate on the U.S. market. This bias frequently leads to portfolios without diversification that can improve the investor's risk-adjusted rate of return.

Loss Aversion
Some people will irrationally hold losing investments for longer than is financially advisable because of their loss aversion bias. For example, suppose an investor makes a speculative trade, and it performs poorly frequently. In that case, he will continue to hold the investment even if new developments have made the company's prospects more dismal. In Economics 101, students learn about "sunk costs" - costs that have been wholly incurred - and they should typically ignore such costs in decisions about future actions. Only the future potential risk and return of an investment matter. The inability to be prepared for an investment gone awry can lead investors to lose more money while hoping to recoup their original losses.
This bias can also cause investors to miss the opportunity to capture tax benefits by selling investments with losses. Realized losses on capital investments can offset first capital gains, up to $3,000 of ordinary income per year. Investors can reduce their tax liabilities by using capital losses to offset regular income or future capital gains.

Anchoring
Aversion to selling investments at a loss can also result from an anchoring bias. Investors may become "anchored" to the original purchase price of an investment. For example, if an investor paid $1 million for his home during the peak of the frothy market in early 2008, he might insist that what he produced is the home's actual value, despite comparable homes selling for $700,000. This inability to sit in the new reality may disrupt the investor's life should he need to sell the property, for example, to relocate for a better job.

Following The Herd
Another common investor bias is following the herd. When the financial media and Main Street are bullish, many investors will happily put additional funds in stocks. However, high prices soar. However, when stocks trend lower, many individuals will not invest until the market has shown signs of recovery. Hence, they can't seem to purchase supplies if they're most heavily discounted.
Baron Rothschild, Bernard Baruch, John D. Rockefeller and, most recently, Warren Buffett have all been credited with the saying that one should "buy when there's blood in the streets." But, unfortunately, following the herd often leads people to come late to the party and buy what appears on the market.

To illustrate, gold prices more than tripled in the earlier three years, from around $569 an ounce to more than $1,800 an ounce at this summer's peak levels, yet people still eagerly invested in gold as they heard of others' past success. Moreover, given that most gold is used for investment or speculation rather than industrial purposes, its price is highly arbitrary and subject to wild swings based on investors' changing sentiments.

Recency
Often, following the herd is also a consequence of the recency bias. The return investors earn from mutual funds, termed an investor return, is typically lower than the fund's overall return. This is not because of fees but rather this website the timing of when investors allocate money to specific funds. Funds typically experience more significant new investment inflows following periods of good performance. According to a study by DALBAR Inc., the average investor's returns lagged those of the S&P 500 index by 6.48 percent per year for the 20 years before 2008. The tendency to chase performance can seriously harm an investor's portfolio.

Addressing Investor Biases
Step one to solving a problem is acknowledging that it exists. Then, after identifying their biases, investors should seek to lessen their effect. Whether working with financial advisers or managing their portfolios, one way to do so is to make a plan and stick to it. An investment policy statement puts forth a prudent philosophy for a given investor. It describes the types of investments, investment management procedures and long-term goals that will define the portfolio.
The principal reason for developing a written long-term investment policy is to prevent investors from making short-term, haphazard decisions about their portfolios during economic stress or euphoria, which could undermine their long-term plans.
The development of an investment policy follows the basic approach underlying all financial planning:
Assessing the investor's financial condition.
Setting goals.
Developing a strategy to meet those goals.
Implementing the strategy.
Regularly reviewing the results and adjusting as circumstances dictate.
Using an investment policy encourages investors to become more disciplined and systematic, which improves the odds of achieving their financial goals.
Investment management procedures might include setting a long-term asset allocation and rebalancing the portfolio when distributions deviate from their targets. This technique helps investors systematically sell assets that have performed relatively well and reinvest the proceeds in assets that have underperformed. Rebalancing can help maintain the appropriate risk level in the portfolio and improve long-term returns.
Selecting the appropriate asset allocation can also help investors weather turbulent markets. While a portfolio with 100 percent stocks may be suitable for one investor, another may be uncomfortable with even a 50 percent allocation to stocks. Palisades Hudson recommends that all the time, investors set aside any assets that they may need to withdraw from their portfolios within five years in short-term, highly liquid investments, such as short-term bond funds or money market funds. The appropriate asset allocation in conjunction with this short-term reserve should give investors more confidence to stick to their long-term plans.

While not essential, a financial adviser can add a layer of protection by ensuring that an investor adheres to his policy and selects the appropriate asset allocation. In addition, an adviser can provide moral support and coaching, improving an investor's confidence in her long-term plan.

Thinking Ahead
We all bring our natural biases into the investment process. Though we cannot eliminate these biases, we can recognize them and respond in ways that help us avoid destructive and self-defeating behaviour.
Planning and discipline are the keys. Investors should think critically about their investment processes rather than letting the subconscious drive their actions. Adhering to a long-term investment plan will prevent biases from influencing investor
behaviour and should help protect investors from avoidable mistakes.

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