FDP Special Market Commentary

July 9, 2020

WHAT ARE BEHAVIORAL BIASES AND HOW THEY HURT YOUR INVESTMENT RETURNS

 

          Do you think that you make sound and thoughtful investment decisions? How about in times of high volatility and stress? Do you feel the pain of loss more than the joy of gain? Behavioral Finance and the underlying study of “investment biases” forms a foundation for the tug-of-war that investors sense between their analytical brains and their emotions.  Here are seven common biases that may be impacting your investment performance. How many have you experienced?

Loss Aversion

People often feel the pain of loss more than the joy of gain. Loss aversion takes hold when people recall investment portfolio declines more vividly than gains, even when the gains are greater. The takeaway here is to have a strategy for managing downside losses when they occur and avoid emotional decision-making.

Confirmation Bias
People are drawn to information that validates their existing beliefs and opinions. An investor that has a belief about market conditions will gravitate toward information sources that validate that belief and ignore or minimize anything that is contrary. The best way to overcome this bias is to consider information from multiple sources.

Mental Accounting

People often view different pots of money differently. For example, money earned at a job may be viewed differently than money from an inheritance. This can affect the way the money is spent or invested. Another example is when someone inherits stock from a relative or owns stock from a company they used to work for. People can become emotionally involved with owning certain stocks. When people own stock from the company they work for, they’re more prone to hold on to the stock out of a feeling of loyalty, even if it’s a bad investment and they’re not diversified.

Recency Bias

People tend to chase investment performance even as the asset class is peaking and is likely to go lower. Because the investment has been climbing recently, investors believe that will remain the case. Past performance can be a powerful driver of investment sentiment because few investors want to feel left behind.  Gold is a great example. This asset class historically peaks during times of high global uncertainty and volatility, yet the duration of the upward movement tends to be relatively short. Even so, many investors will want to purchase gold for several years after the yellow metal plummets.

Hindsight Bias

People who tend to say or think “I knew this would happen” may experience a detrimental effect on their investment portfolios. People tend to overestimate the accuracy of their predictions and that can often lead to a false sense of security when making investment decisions. In turn, this can lead to excessive risk-taking behavior.

Herd Mentality

People don’t want to be left out of a trend or movement. Investors are more likely to purchase or sell a stock, for example, when the larger herd is stampeding into or out of that same stock, but it doesn’t mean that it’s the right move. Investors that buy when the market is high and sell when the market is down are more than likely highly influenced by the herd mentality.

Illusion of Control Bias

People who believe that they should be able to pick the right stocks or “someone should have the ability to time the market to achieve superior results consistently” are setting themselves up for disappointment.  People who live under this belief have trouble coming to terms with the irrationality and variability of markets and the impossibility of their expectations. The outcome is often financially damaging, and they rationalize that while their beliefs were correct, “the person who pushed the buttons wasn’t competent.”

Conclusion

How many of the investments biases seem familiar? The best way to combat your investment biases is to first be aware that they exist. Second, to have a plan in place that includes an Investment Policy Statement that defines how investment decisions will be made in the future. This investment process will help you minimize the negative impact of poor decision-making during the times of stress. Have a plan and then stick to the plan.

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As always, I’m available to answer your questions and to be of service.

 

Mark Chandik
President & Chief Investment Officer

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