In a 1980 landmark study, Swedish scholars revealed that most people have a superior view of their skills and risk-taking ability. The topic: How good of a driver are you? Respondents were strongly biased in believing themselves more skillful and less risky1 than the average motorist. Source: NLG
Primal behaviors and biases are present in just about everything we do, especially financial planning. In fact, instincts inspire more decision making than many investors care to admit. But more proof is available that behavior tends to rule our financial choices most of the time.
WE ALL BEHAVE
In 2000, Irrational Exuberance2 laid the foundation to understanding investor behavior. Just two years later, the Nobel Prize in Economics lauded the integration of human psychology into economic and financial market analysis.3 Behavioral finance was born. Pushing further, 2007’s Inside the Investor’s Brain4 concluded that most humans were just “not mentally hardwired to be effective investors.”
Fast forward to now, investor behavior still foils many best-laid financial plans.
But knowing how such human tendencies manifest themselves is a big step to staying objective and on the right path to a desired financial goal.
BREAKING BAD… BEHAVIOR
Here are just a few of the more common investor behavior traps, along with some ideas to try and stay ahead of them.
Anchoring or Confirmation–This occurs when we pay attention only to data that support our initial opinion. We then might ignore or miss views that contradict our stand. For example, if we think an SUV should cost $18,000, then a price of $16,000 seems great–even if the ride’s market value is $15,000.
Suggestion: Stay open and objective to relevant information from all sides and you’ll make better decisions.
Loss or Regret Aversion–We can be so worried about the possibility of any losses that we avoid doing anything at all. Consequently, our would-be saferoom shields us from everything, including any growth potential.
Suggestion: If your risk tolerance and investment time frame allow, consider thinking broader, and spreading your investments across different, non-correlated asset classes. This is called diversification5 and the principle is that when some of your investments are down, others are up, which may reduce your risk over time.
Hindsight–“I knew that would happen,” says just about everyone, whether it’s a bubble burst, a company’s collapse or a market downturn. Chances are, no they didn’t. But it’s easy to get trapped into retro-connecting the dots to reinforce our belief that we could have seen whatever it was coming before it occurred. This bias can distort our recollections of what actually happened to the extent we apply them to current decisions, and often with too much confidence for our own good.
Suggestion: Appreciate history, learn from mistakes, but don’t over rely on the past to navigate today’s realities toward the future.
Herding and “FOMO”–What do tulips, dot.com stocks and housing have in common? They led to investment bubbles that did not end well for those who chased them. When others are crushing it in the markets, our animal spirits make us want our cake too. So, we follow the crowd–even if off a cliff–for “fear of missing out” (FOMO) on the seemingly unlimited, immediate rewards set before us.
Suggestion: Be a disciplinarian for yourself, not a disciple to others, and make informed, emotion-free decisions to invest over the long term in things you truly understand.
Familiarity–It’s natural to want to lean more heavily on what we know and like to avoid the uncertainties of new or strange investment types. It may feel safer now, but it restricts diversification opportunities, which may put you at the risk of having too many eggs in one familiar basket.
Suggestion: A financial professional is your best source to understand the changing world of investment products and how they can help, or hinder, your dynamic situation.
MARKETS OVER MINDS
When you’re aware of your tendencies, productivity can go up. That is, investors–driven by emotions and short-term influences–move in and out of the market so frequently that they leave a lot of potential money on the table, according to Dalbar, Inc.6
For instance, Dalbar revealed a 4.9% gap between the market’s average annual return (15.8%) and the average equity mutual fund investor’s annual return (10.9%) over the past five years. This painful difference is what author and retired financial advisor Carl Richards first coined “The Behavior Gap.”7
For the longer, 20-year period, the gap significantly narrowed to just 1.9%, showing that investor productivity rises when they just let their assets rely more on the market than their mindset over time.
Not giving in to our instincts is easier said than done. Did we learn from the Great Financial Crisis, whose origins were rooted in some of these behaviors and biases? Perhaps, but as we mark its 10th anniversary, we’re seeing new signs of herding again, especially in the index funds space.
Time may heal wounds from the past, but can it change instinctive human behavior going forward? Let’s be logical and just wait and see what happens.
Mark Bates contributed to this article.
1 “Are We All Less Risky and More Skillful than Our Fellow Drivers?” by Ola Svenson, University of Stockholm: 1980.
2 “Irrational Exuberance,” by Dr. Robert J. Schiller. Princeton University Press: 2000.
3 Daniel Kahneman and Vernon L. Smith, 2002 Royal Swedish Academy of Sciences: press release
4 “Inside the Investors Brain: The Power of Mind over Money,” by Richard L. Peterson. Wiley: 2007.
5 Diversification does not assure a profit or guarantee against loss. Investing involves risk, including the potential for loss of principal. Past performance does not guarantee future performance.
6“Quantitative Analysis of Investor Behavior, 2018,” Dalbar, Inc. www.dalbar.com. Returns are for the period ending 12/31/17. Average equity investor performance results are calculated using data supplied by the Investment Company Institute. The market returns were calculated using S&P 500 Index returns.
7 “The Behavior Gap: Simple Ways to Stop Doing Stupid Things with Money” by Carl Richards. The Penguin Group: 2012.
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