By Echo Huang, CFA, CFP®, CPA
A recent study by DALBAR, a financial research firm, has confirmed that investors who try to time the stock market often dive into the market at the top and flee at the bottom. This fact has actually caused investor results to significantly lag the broader markets over the long haul.
DALBAR's most recent study shows that over the last 20 years, through December 31, 2017, the S&P 500 has produced an average annual return of 7.20%. However, over that same period, the average equity fund investor has earned only 5.29%. Bloomberg Barclays US Aggregate Bond Index has produced an average annual return of 4.98%. However, over the same period, the average fixed-income fund investor has earned only 0.44%.
Most of traditional economic and financial theory is based on the assumption that individuals will act rationally and consider all available information in their decision-making process, and that markets are efficient. Behavioral finance challenges these assumptions and explores how individuals and markets actually behave.
Emotional biases are related to feelings, perceptions, or beliefs about elements, objects, or the relations between them, and can be a function of reality or of the imagination. In the world of investing, emotions sometimes cause investors to make suboptimal decisions.
Cognitive errors, in fact, are more easily corrected than emotional biases. Cognitive errors stem from faulty reasoning, therefore better information, education and advice can often correct for them. Most cognitive biases can be “moderated” - to moderate the impact of bias is to recognize it and attempt to reduce or even eliminate it within the individual.
In this post, we'll examine the six key emotional biases, the consequences of the bias, and offer guidance on detecting and overcoming the bias. The first step is to be aware that these biases exist and then take actions to overcome them in order to have a successful investing experience.
- Endowment bias is an emotional bias in which people value an asset more when they hold rights to it than when they do not. Investors may irrationally hold on to securities they already own, a bias particularly true regarding their inherited investments. An investor may hold an inherited municipal bond portfolio due to their emotional attachment, when a more aggressive asset mix may be more appropriate.
Consequences include failing to sell off certain assets and replace them with other assets. Investors may continue to hold classes of assets with which they are familiar. They may be reluctant to purchase assets with which they have less experience. Familiarity adds to owners’ perceived value of a security.
In the case of inherited investments, investors should ask questions such as, “If an equivalent sum to the value of the investments inherited had been received in cash, how would I invest the cash?” Often, the answer is into a very different investment portfolio than the one inherited. Furthermore, explore the deceased’s intent in owning the investment and bequeathing it.
- Status quo bias is a bias in which people do nothing instead of making a change. People are generally more comfortable keeping things the same than they are with change and thus do not necessarily look for opportunities where change may be beneficial. In the absence of an apparent problem requiring a decision, the status quo is maintained. If given a situation where one choice is the default choice, people will frequently let that choice stand rather than opting out of it and making another choice. For example, companies that enroll employees in 401(k) plans but give the employees the ability to opt out of the plan have a much higher participation rate than companies where employees have to opt into the plan.
Consequences include unknowingly maintaining portfolios with risk characteristics that are inappropriate for their circumstances. Status quo bias also leads to failing to explore other opportunities.
Status quo bias may be exceptionally strong and difficult to overcome. Education is essential. Investors should quantify the risk-reducing and return-enhancing advantages of diversification and proper asset allocation.
For example, my client Mrs. Olson received many shares of ABC stock with a low cost basis from her father who had worked for ABC company for many years, and it became a majority of her portfolio because she didn’t sell a single share. In addition, she received employer stock in her 401(k) plan that she hadn't sold over the past twenty years. Two stocks alone took up almost 85% of her entire portfolio. Based on her risk tolerance assessment, she is a conservative investor, but her portfolio at that time was very aggressive and undiversified. She had status quo bias but luckily she hadn't experienced any problems in owning these two stocks as they had performed well. I showed her what could happen to her overall wealth levels if ABC stock collapsed. I advised her to start selling the employer stock inside her 401(k) first, and without any tax impact she diversified into various core fund choices, then we started setting up target prices to gradually sell ABC stock to diversify. In addition, she transferred some ABC stock to her donor-advised fund with the American Endowment Foundation every year to reduce taxes on the capital gains.
Now her portfolio is much more diversified and she is more comfortable about taking some calculated risks due to positive investing experience and education about risk and returns trade-offs.
- Self-control bias is a bias in which people fail to act in pursuit of their long-term, overarching goals because of a lack of self-discipline. When it comes to money, people may know they need to save for retirement, but they often have difficulty sacrificing present consumption because of a lack of self-control. The apparent lack of self-control may also be a function of hyperbolic discounting that is the human tendency to prefer small payoffs now compared to large payoffs in the future.
Consequences include saving insufficiently for the future. Upon realizing that their savings are insufficient, investors may do the following:
a) Accept too much risk in their portfolios in an attempt to generate higher returns. In this attempt to make up for less than adequate savings, the capital base is put at risk.
b) Cause asset allocation imbalance problems. For example, some investors may prefer income-producing assets in order to have the income to spend. This behavior can be hazardous to long-term wealth because income-producing assets may offer less total return potential, particularly when the income is not invested, which may inhibit a portfolio’s ability to maintain spending power after inflation.
Investors should ensure that a proper investment plan is in place and should have a personal budget. Plans need to be in writing so that they can be reviewed regularly. Failing to plan is planning to fail. Adhering to a saving plan and an appropriate asset allocation strategy are critical to long-term financial success.
- Loss-aversion bias is a bias in which people tend to strongly prefer avoiding losses as opposed to achieving gains. A number of studies on loss aversion suggest that, psychologically, losses are significantly more powerful than gains.
Loss aversion leads people to hold their losers even if an investment has little or no chance of going back up. Similarly, loss-aversion bias leads to risk avoidance when people evaluate a potential gain. Given the possibility of giving back gains already realized, investors lock in profits, thus limiting their upside profits.
Consequences include holding investments in a loss position longer than justified by fundamental analysis. Loss-aversion bias also leads to selling investments in a gain position earlier than justified by fundamental analysis. Investors sell winning investments because they fear that their profit will erode.
Myopic Loss Aversion: Benartzi and Thaler (1995) conceived myopic loss aversion as a bias that combines aspects of time horizon-based framing, mental accounting, and loss-aversion biases. Investors, presented with annual return data for stocks and bonds (showing potential gains and losses), tend to adopt more conservative strategies (lower allocation to equities) than those presented with longer-term return data, such as 30-year compound returns. Investors place stocks and bonds into separate mental accounts rather than thinking of them together in a portfolio context; they seem to be more concerned with the potential for short-term results. Benartzi and Thaler use the term myopic loss aversion in reference to this behavior. They argue that investors evaluate their portfolios on an annual basis and as a result overemphasize short-term gains and losses and weigh losses more heavily than gains.
The probability of observing a loss is higher when the frequency of evaluation is high. If losses cause more mental anguish than equivalent gains cause pleasure, the experienced utility associated with owning stocks is lower for the more myopic investor (Kahneman, Walker, and Sarin, 1997). Over time, the myopic investor is expected to gravitate to a lower level of risk.
It is impossible to make experiencing losses any less painful emotionally, but analyzing investments and realistically considering the probabilities of future losses and gains may help guide the investor to a rational decision.
- Overconfidence bias is a bias in which people demonstrate unwarranted faith in their own intuitive reasoning, judgments, and/or cognitive abilities. This overconfidence may be the result of overestimating knowledge levels, abilities, and access to information. Overconfidence may be intensified when combined with self-attribution bias. Self-attribution bias is a bias in which people take credit for successes and assign responsibility for failures.
There are two basic types of overconfidence bias rooted in the illusion of knowledge: prediction overconfidence and certainty overconfidence. Both types have cognitive and emotional aspects: both types demonstrate faulty reasoning combined with “gut feel” and such emotional elements as hope. Hope frequently underpins the probabilities assumed when investment decisions are made in an overconfidence state.
As it relates to investing, overconfidence is what makes us think we are better at spotting the next hot stock or investment trend. It could also lead to inadequate diversification as you think you know which stock or asset class is positioned to outperform. It could also lead to trading excessively and experiencing a lower return than that of the market.
Investors should review their trading records, identify the winners and losers, and calculate portfolio performance over at least two years. A conscious review process will force investors to acknowledge their losers because a review of trading activities will demonstrate not only the winners but also the losers and the amount of trading.
When reviewing unprofitable decisions, look for patterns or common mistakes that perhaps you were unaware that you were making. Note any such tendencies that you discover, and try to remain mindful of them by brainstorming a rule or reminder such as: “I will do X in the future” or “I will not do Y in the future.”
- Regret-aversion bias is an emotional bias in which people tend to avoid making decisions that will result in action out of fear that the decision will turn out poorly. Simply put, people try to avoid the pain of regret associated with bad decisions. They are reluctant to sell because they fear that the position will increase in value and then they will regret having sold it. Regret from an action taken is called an error of commission, whereas regret from an action not taken is called an error of omission. Regret is more intense when the unfavorable outcomes are the result of an error of commission versus an error of omission. Thus, no action becomes the preferred decision.
Consequences include being too conservative in their investment choices as a result of outcomes on risky investments in the past. This behavior can lead to long-term underperformance and potential failure to reach investment goals. In addition, regret-aversion bias leads to engaging in herding behavior. It seems safe to be with the crowd, and a reduction in potential emotional pain is perceived. Choosing the stocks of less familiar companies is perceived as riskier and involves more personal responsibility and greater potential for regret.
In overcoming regret-aversion bias, education is essential. Investors should quantify the risk-reducing and return-enhancing advantages of diversification and proper asset allocation. To prevent investments from being too conservative, investors must recognize that losses happen to everyone and keep in mind the long-term benefits of including some risky assets in portfolios.
- Which biases do you think you tend to have?
- What are the challenges you have experienced recently to overcome the biases?
- What was your worst investment decision and what lessons have you learned from it?
Next post, we'll examine some cognitive biases that affect how we make investment decisions.
Source: Michael M. Pompian, CFA, Sunpointe Investments. 2019 CFA Level III Portfolio Management