Common (Costly) Mistakes
Investing one’s money is inherently an emotional endeavor. Often, the emotional detachment we provide as investment advisors is one of our most impactful value-adds. This is particularly true during market crises.
As much as we would like to imagine we are capable of rationality, studies of investor behavior indicate we are far from logical and, at times, are capable of incredible irrationality. Therefore, it should be no surprise that our emotional biases have the power to negatively affect the investment process if left unchecked. While this note focuses on emotional biases, we also suffer from many cognitive biases. Both are a hindrance in the context of portfolio management. When investing our own money our judgment is often clouded, leading us astray and resulting in the implementation of portfolios with sub-optimal risk-return profiles.
The purpose of this note is to feature a few common mistakes in the portfolio management process and the related biases from which they arise.
Overconfidence bias is a bias where investors “demonstrate unwarranted faith in their own intuitive reasoning, judgments, and/or cognitive abilities”.[i] Studies have shown that timing the market through asset allocation, factor, or sector exposure are futile efforts that do not improve returns. An effort to time the market is inherently related to one’s overconfidence bias.
Decision risk is the risk that an investor abandons the long-term plan at the most inopportune time. For example, it is epitomized by the investor who had a plan yet sold their stock anyways in March 2009, thereby losing out on the subsequent market gain. It can result in permanent capital loss, one of the worst outcomes for an investor.
Loss aversion is one of the most common and impactful emotional biases. While everyone dislikes losing money, investors tend to hold on to fallen stocks longer than they should, thus avoiding the pain of realizing the loss. It can also result in selling winners too early to capture gains. Another byproduct is excessive trading. In general, excessive trading has been shown to lower returns, all else equal.
Status quo bias is a bias that leads investors to do nothing. For example, instead of recalibrating an out-of-balance portfolio, the investor often does nothing instead of changing allocations back to pre-determined levels. It is less a function of conscious choice than that of inertia but lowers returns, nonetheless.
Regret Aversion bias manifests in an investor’s avoidance of a decision which they may later regret. Sometimes they hold too much cash for fear of investing at the “wrong time”. At other times they allocate too much to low-yielding CDs due to a fear of losing money in the markets. The evidence is clear that, over time, equities are a key driver of portfolio growth, and any allocation to cash or CDs drags on portfolio performance.
WHAT IT ALL MEANS
All of the aforementioned biases result in lower portfolio returns than if the behavior was not exhibited. But all is not lost. Awareness of these issues is the first step. Proper education can lessen many of our biases, allowing us to mitigate their manifestations or craft portfolios that reasonably accommodate them. At the end of the day, it is most important to develop a plan and a portfolio that will work for you through the inexorable peaks and troughs of the market. One that will get you to where you want to be.
Kind regards,
Ben
[i] CFA Program Curriculum. Level 3, 2021. [Charlottesville, VA]: CFA Institute; John Wiley and Sons, 2020.
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