Research shows that individuals investing directly in stocks or in mutual funds tend to have substantially lower returns than do comparable equity indices or the funds themselves.
This underperformance is attributable mainly to human behavioral biases, either cognitive or emotional, which have long been the focus of behavioral finance literature.1
Behavioral finance, which gained popularity through the pioneering work of Amos Tversky and Daniel Kahneman, has identified the cognitive flaws that cause investors to make irrational and systematic errors. By recognizing that they and their managers are subject to these flaws and by taking steps to mitigate their effects, however, individuals can substantially improve their investment results.
Of the many deficiencies researchers have identified, one of the most significant is loss aversion. This bias arises from people’s tendency to feel the pain of loss more than the joy of similar gain. Because of loss aversion, investors tend to hold falling stocks too long and sell rising stocks too early. Loss aversion (closely related to regret avoidance) can also cause individuals to invest in order to try to catch up with others in a rising market.2
The irony is that while investors are unwilling to realize losses in a stable or rising market, they often bail out completely in the midst of major bear markets and do not get back in until late in the market recovery. For example, there were investors still selling and consultants advising complete liquidation in early 2009, even though retail sales were improving, banks were starting to make profits and the cyclically adjusted P/E ratio was well below average.
Even when there was significant evidence of an improving U.S. economy, investors were still unwilling to re-commit. Two behavioral flaws explain this counterproductive behavior: availability bias and confirmation bias.
Availability bias is the tendency to ignore things that have not occurred recently and to focus only on recent events. Thus, during a financial crisis, people forget that economic and market recoveries occur; and, likewise during financial bubbles, they forget about market implosions.
Confirmation bias, meanwhile, implies an over-reaction to public information that supports investors’ preconceptions and under-reactions to information that contradicts it. In the late stages of a bear or bull market, investors become convinced that their pessimistic or optimistic view will remain intact and disregard contrary indicators, such as improving or declining earnings and sales.
Even when there was significant evidence of an improving U.S. economy, investors were still unwilling to re-commit. Two behavioral flaws explain this.
Such behavioral biases cannot be avoided, but their effects can be diminished. Overall decision improvement requires recognizing one’s behavioral biases if possible, resisting the temptation to engage in such behavior and developing and following systematic investment strategies and trading rules.
Daniel Kahneman noted, in his 2011 book, Thinking Fast and Slow, that these investment strategies are difficult for individual investors to develop and maintain. They require records, consistent processes, a focus on the individual pieces, one at a time, and accountability. Selective de-biasing through training interventions or the use of incentives or changes in presentation has been somewhat more successful.
Overall, then, the best course of action for investors to minimize the damage from their behavioral biases is to work with advisers, fund managers and separate account managers who have sound processes in place for meeting specific investment goals.
1Russell Kimmel, “Mind the Gap,” Morningstar, February 27, 2014. See also: Todd Feldman, “Behavioral Bias and Investor Performance,” AlgorithmicFinance.org, 2011.
2Whereas stock investors tend to hold positions that have declined in value and sell positions that have appreciated in value, regardless of fundamentals (the “disposition effect”), mutual fund investors tend to do the opposite.
All information contained herein is based on past performance and is not intended to be indicative of future results. There is no guarantee that historical risk and rate of return will persist in the future. The views and opinions expressed above are those of the portfolio management team at the time of writing and are subject to market, economic and other conditions that may change at any time; and, therefore, actual results may differ materially from those expected. This material does not constitute a recommendation to the suitability of any product or security and does not constitute an offer to buy or sell any financial instrument or to participate in any trading strategy. The analysis provided should not be relied upon as the sole factor in an investment decision. All investments contain associated inherent.
This article was originally published in the June/July 2016 issue of Worth.