It pays to be aware of our blind spots.
The field of behavioral economics is relatively new, but the value of reflecting on one’s motivations and judgements has long been acknowledged. The famous phrase, “Know thyself,” from the ancient Greeks, is one that is particularly relevant when it comes to investing. Although classical economics assumes people make rational choices, behavioral economics has come to identify common biases that can adversely affect portfolio results. Below, we offer a quick look at several of the most common investor behavioral biases and steps you can take to avoid them.
Common Biases That Impact Investment Results
- Recency bias is the tendency to overweight the importance of recent observations relative to the full set of observations. This is often seen in investors chasing the latest returns and being overly impressed by hot investment funds and fads. For example, if you began the year by reducing exposure to an asset class largely in response to the previous year’s returns, you may have a recency bias. The issue with this tendency is that, in practice, prior short-term returns poorly predict future returns, making these types of reactions counterproductive.
- Overestimating one’s ability to control events is illusion of control. Investors may exhibit this bias when they believe they can time markets. But many markets, including the U.S. stock market, are highly competitive and have demonstrated unpredictable short-term fluctuations – suggesting that attempts to predict future price movements are futile and will not be consistently rewarded. Illusion of control is fortified by hindsight bias, which is the tendency to perceive past events as predictable, even if they were not.
- If you find yourself more upset with losses than pleased with gains, you could be exhibiting loss aversion. This behavior is consistent with the marginal utility of wealth, where a dollar is valued less with increasing levels of wealth. This bias can result in a misalignment between your portfolio and your true risk aversion, as well as costly attempts at market timing.
- Familiarity bias is the propensity for favoring the familiar over the unfamiliar. This may sound natural, but it can have undesirable results. For example, investors frequently exhibit home bias, or the preference for owning equities of companies based in their home country – even though a global equity allocation offers better diversification. This is particularly a problem for investors domiciled in countries with small capital markets. But even U.S. investors give up diversification benefits when they have a home bias.
- Investors exhibit mental accounting when they separate their assets or liabilities into non-interchangeable groups. For example, mental accounts can include goals like retirement, education and bequests – and the sub-portfolios that fund them. But they can also include more concentrated assets with psychological attachments, such as concentrated single-stock positions.
- Mental accounting is also closely associated with endowment bias, defined as the tendency to ascribe more value to assets already owned, and anchoring bias, clinging to an arbitrary price level, such as the purchase price, when making a buy or sell decision.
Common Behavioral Biases
Three Ways To Mitigate Behavioral Biases
There are at least three methods commonly acknowledged to help mitigate behavioral biases when investing. They are education, investment process and goals-based investing.
Recognizing that behavioral biases exist is the first step in mitigation. When making an investment decision, consider if you are being influenced by one or more of the biases discussed. This step may help you reconsider the investment decision more rationally. Some research suggests that professional investors are now largely aware of behavioral biases, but many individual investors are not.
A sound investment process is objectively designed before making specific investment decisions that could be influenced by biases. The process might entail identifying goals and objectives, staying within predetermined allowable asset class ranges, and staying the course until the process is repeated at predetermined intervals.
Goals-based investing provides a framework for informed decision-making, which leads to more rational investing and better investment outcomes. By focusing on the purpose of your assets – which is to efficiently fund your lifetime goals – it produces dynamic asset allocation customized by your unique goals, risk preferences and circumstances.
For more in-depth information about these behavioral biases and steps you can take to mitigate them, including goals-based investing, read From Behavioral Bias to Rational Investing.