Flat Fee Portfolios

Discipline Matters

Common Biases, Mental Shortcuts, and Behavioral Errors >>

At Flat Fee Portfolios, we believe that disciplined investing matters.  Unfortunately, disciplined investing is not easy.  Human nature equips investors with a variety of cognitive biases that can cause undisciplined and costly investment mistakes.  Some of the common investor mistakes include:  over-concentrating in a single stock or a specific type of investment, following the latest investment craze, allowing emotion to override reason, and taking too much (or too little) risk with the overall portfolio. 

A recent study by Dalbar confirmed that many times an investor is his/her own worst enemy.  It found that while the S&P500 generated annualized returns of 9.1% in the years of 1990 to 2010, the average equity fund investor realized only 3.8% over the same period of time.  The difference can be attributed to behavioral errors caused by human nature.

Source: "Quantitative Analysis of Investor Behavior, 2011," Dalbar, Inc. www.dalbar.com

While nothing can change our human nature, an awareness of these biases can help investors avoid potential pitfalls.

Common Biases, Mental Shortcuts, and Behavioral Errors

Anchoring is a bias that causes investors to either hold onto an idea longer than they should, place a disproportionate amount of value on the piece on information they receive, or anchor their perception of value to a specific price point.   The inability to fully incorporate new information causes investors to hold onto poor investments longer than they should.

Availability Bias is a mental shortcut in which investors use readily available information and media to make investment decisions, rather than a disciplined research process. 

Familiarity Bias reflects an investor’s tendency to invest in the known.  Investors may perceive investments they are knowledgeable about as either less risky or more rewarding, and oftentimes both.  Typically the tendency manifests itself in investors concentrating their holdings in their own country (a home country bias) or in the stock of their employer. 

Herd-Like Behavior reflects the tendency of investors to follow the crowd by chasing the latest investment fad.  Driven by greed and fear of missing out, individual investors project past returns into the future and pile in together.   The behavior results in investors consistently buying into the most highly valued segments of the market, leading to sub-par results.  Herding can also lead to selling at the most inopportune times, making investors their own worst enemy. 

Hindsight Bias occurs when events that have occurred in the past look predictable and obvious from the present.  Hindsight bias leads investors to overestimate their ability to discern the likelihood of events occurring in the future, causing overconfidence. 

An Inability to Control Emotions is common.  Most individual investors are easily controlled by two emotions:  fear and greed.  While everyone would like to “buy low and sell high," very often investors, even very intelligent and well-educated investors, do the exact opposite.  They, in effect, “buy high and sell low.”  Investors would be wise to heed Warren Buffett’s advice to “be fearful when others are greedy and greedy when others are fearful.”  Unfortunately, most investors tend to be fearful at the moment of greatest opportunity and greedy at the time of greatest risk. 

Loss-Aversion is an investor’s reluctance to realize a loss.  Investors who exhibit loss aversion hold onto losing investments in the hope that they will recover.  They may even engage in risk-seeking behavior by “doubling down” on a poor investment in hope of recovering losses faster. 

Overconfidence is a cognitive bias that causes investors to err in a number of ways, usually with financially damaging results.  Overconfident investors are often over-concentrated in a specific asset class, sector, or stock.  They often ignore the risk and seek out confirming evidence while ignoring or discounting any disconfirming evidence.  More often than not, increased risk taking is punished with large losses.  Overconfidence can also lead to increased trading which can lead to excessive taxes and fees. 

Recency/Vividness Bias reflects a tendency on the part of individuals to focus on events that are most recent or easiest to recall because they left a psychological impact.  Often in investing the event is a recent market correction, but it can also be a recent run-up.  Since the events are recent or vivid, the tendency is for investors to overestimate the likelihood of the event occurring again and position the portfolio either too conservatively or too aggressively. 

A Status-Quo Bias is inertia, or a lack of decision making.  In many cases, this is because investors seek to minimize their regret.  By maintaining the status quo they avoid the mental anguish associated with realizing an adverse outcome after making a decision.  Examples of regrettable events would be the market rallying after selling out of equities or correcting after investing in equities.  Unfortunately, this bias can result in investors maintaining the status quo with investment portfolios and financial plans not suited to meet their goals and objectives.