The majority of investors in mutual funds will underperform the market time and time again, and it’s not simply a case of picking the wrong fund, paying too much in fees or betting on failing managers. A lot of the underperformance is in your head. Noted value investor Benjamin Graham said it best: “The investor’s chief problem—even his worst enemy—is likely to be himself.”
Dubbed behavioral finance, there are many emotional and psychological factors that influence our decisions when it comes to investing. These behaviors can cause us to work in unpredictable or irrational ways. Basically, the majority of the time we think with our “hearts” and not with our “heads.” Ultimately, that kind of thinking will lead to poor investment decisions and in some cases, big time losses. The sad thing is that no one is immune from behavioral finance issues – accept for a few quant-controlled robots.
While overcoming your own thoughts can be a difficult proposition—even experts behavioral finance still fall victim to these things—knowing what pitfalls abound is a major step in combating the problem. Here at MutualFunds.com, we’ve prepared a look at the seven biggest behavioral biases and how they affect your portfolio choices.
Be sure to also see the 25 Tips Every Mutual Fund Investor Should Know.
1. Recency Bias
When investors think that recent events will continue forever, this is a case of recency bias. However, predicting the long term future based on what has recently occurred is no more accurate than flipping a coin. A prime example is that internet boom/bust of the late 1990s. Investors continued to think that the valuations of various dotcom stocks—even though they had no profits or real revenues—would continue to rise and rise. Every market and sector is prone to boom and bust. Over the longer run, the cycle is very varied.
When we invest, we need to remember that what happened yesterday or last week may or may not be part of the long-term trend.
2. Choice Paralysis
We like to have a multitude of choices. A trip to your local grocery store’s bread aisle not only reveals white or wheat, but many varieties of each. However, when it comes to investing, having a ton of choices may not be all that great. In fact, it actually causes most investors to become paralyzed. When faced with too many fund choices, many investors won’t actually make an informed decision and invest. According to a Vanguard study focused on its 401(k) clients, those plans with more investment choices actually had less employee engagement rates.
Overcoming choice paralysis is relatively easy. You need to not be intimidated by all your choice. Use tools like screeners, read the various fund literature, and invest.
See our list of the Best 25 Online Tools for Mutual Fund Investors.
We all want to be independent contrarian investors. Unfortunately, most of us run with the herd. Herding is the tendency for individuals to mimic the actions of a larger group. We all buy the same stocks, we all flood bonds at the same time. This kind of behavior happens all the time – for both individual investors as well as institutional ones. Sadly, by the time most investors meet-up with the herd, the trend is almost over. That’s when mom and pop investors are left holding the bag.
Herding is precisely why value investing works for some investors. By not following what the market is doing and by buying the opposite, investors are able to profit when the tide shifts. It can be difficult to do, but it will ultimately be worth it.
4. Loss Aversion
When we lose money, we tend to feel it more than when we win. Placing a bad trade and being down $100 feels worse than winning a $100. Because of this, we try to limit losses at the expense of gains. A prime example of this was during the beginnings of the Great Recession. Many investors sold at the wrong time and went to cash. However, had they just stayed invested, they would have made their money back and then some in the subsequent years’ worth of returns.
The easiest way to overcome loss aversion is to stay focused on your goals, timeline and analysis. The longer your timeline, the easier it is overcome your fear of loss.
5. Confirmation Bias
One of the biggest problems investors face is cherry-picking data that already confirms what they are thinking. Essentially, confirmation bias is our inability to separate our inclinations and dislikes from what is really going on. You think that emerging markets are going to perform well and you tend to read articles that point to and support that picture. The problem is that by only looking for information that supports your ideas, you’re only getting half the picture.
Overcoming confirmation is as simple as reading, watching and understanding all the data available, while making sure that there is at least one source that can be a “dissenting voice of reason.” You need a contrary viewpoint to be successful.
6. Optimism and Overconfidence
Having a good year in the markets? That overconfidence could be forcing you to take unnecessary risks with your portfolio. When we are riding high, we tend to think that we are invincible. That feeling helps reinforce the idea that we never make mistakes, our picks and investments always win, etc. When combining this feeling with other behavioral finance quirks, investors will make very poor investment decisions.
It’s OK to be happy with your portfolio’s recent performance, but you need to remember that any future investment picks need to be fully analyzed before you pull the trigger. You’re not perfect and you do and can make poor decisions.
7. Bias Blind-Spot
This is a case of self-denial. We think that these sorts of behavioral finance quirks only apply to other “lesser” investors and they could never happen to us or our portfolios. The truth is, they happen to everyone. From top hedge fund managers to young investors making their first contribution to their 401(k)’s. We ignore the various biases and then suffer the consequences when they blow-up in our faces.
The Bottom Line
Truth be told, investors’ brains can be their worst enemies. We are all subject to certain ways of thinking that can sabotage our portfolios and futures. By recognizing these behavioral finance issues, we can begin to overcome them when we invest. It’s not easy to do as the seven items on this list are very ingrained in our heads. However, simply knowing they exist is a powerful first step in beating them.
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