There’s a tug of war between our hearts and minds in making investment decisions. When emotions win—as they often do—we become our own worst enemies and underperform the broader market. According to DALBAR research, one of the single biggest variables in investment performance is investor behavior. It’s primarily responsible for the continual underperformance of the average mutual fund equity investor versus the U.S. equity market.
These findings don’t surprise me. I’ve seen firsthand that emotional and behavioral biases can lead to poor decisions and ultimately, disappointed performance. The biases I witness most often are loss aversion, herding, media response, overconfidence, and familiarity. Perhaps you’ll recognize one or more of these from your own decision-making experiences.
Loss Aversion
Many clients who seek my firm’s advice mistakenly believe they can consistently earn high returns with little to no risk. They’ve made some poor financial decisions in an attempt to avoid loss, often with the belief that what goes down must always go up. They’ve sold the investments that have gone up in price and are waiting for the “losers” to climb. In many cases, they’re retaining a less valuable business and sold one that was more profitable. Think about that in terms of real estate: Would you hang on to a house in a declining neighborhood or would you sell it?
Herding
People tend to feel safer when they follow the crowd. This inclination to follow the actions of others is known as herding behavior. Investors engage in herding when they sell because other people are selling and buy because others are jumping into the market. As a result, they tend to sell low and buy high, which is contrary to common sense and detrimental to investment performance. Warren Buffett has profited from bucking the crowd. He’s built tremendous wealth as a contrarian investor and is quoted as saying “You pay a very high price in the stock market for a cheery consensus.” I share the same opinion.
Media Response
The media’s job is to maximize readership and viewership and they’ve found the best way to accomplish this is by focusing on crises and negative news. Checking the day’s financial news can lead investors to narrow their focus and lose sight of the big picture. The heated discussions about market events and the opinions of “experts” fuel emotions and lead to snap decisions based on fear and greed. Using your head, not your heart, and taking a long-term view of the market can result in far better performance with much less angst.
Overconfidence
Some investors believe they’re smart enough to time the market and no one can tell them otherwise. Others have unbounded optimism, with a “It can’t happen to me” attitude.
Overconfident investors like these have a tough time listening to objective investment advice. Usually, they come down to earth only after they’ve had a bad experience in the market, and rebuild their portfolios to include more downside protection. Of course, the consequences of overconfidence can be worse for older individuals who have less time to recoup their losses.
Status Quo Bias
We tend to feel more comfortable maintaining things as they are and can be reluctant to make changes even when we know we should. This is called status quo bias and it’s responsible for many poor financial decisions, including failing to adopt a more conservative asset allocation as time passes. Some individuals who’ve invested aggressively for decades are very uncomfortable taking less risk and don’t change their asset allocation to reflect their time horizon or they make changes too late.
One of the biggest benefits of working with a financial advisor is having access to their objectivity and rationality with respect to investment decisions. In fact, one of the primary reasons most wealthy individuals and families don’t manage their own money is because they want unbiased advice.
Emotional and behavioral biases are largely automatic and reflexive, which makes them difficult to control. At the very least, learn what triggers an emotional reaction in you. And don’t be afraid to turn to a financial professional to help you remain cool-headed and avoid impulsive decisions you’d live to regret.