Why investors are their own worst enemy: behavioral biases in investing

  • Investors have bias­es that influ­ence their deci­sions
  • They invest when the mar­ket has gone up — and there­fore when the chances of it going fur­ther up have decreased. And of course, they sell at the worst pos­si­ble time too.
  • This bad prac­tice affects per­for­mance neg­a­tive­ly, espe­cial­ly in volatile mar­kets.
  • The solu­tion is to plan your invest­ment and even bet­ter to auto­mate it.

An investor can make his mon­ey grow effi­cient­ly through pas­sive man­age­ment. A huge advan­tage with this method is what’s called “behav­ioral finance”.

Indeed, when you choose and pick stocks your­self, you can become your own worst ene­my. Your psy­chol­o­gy push­es you to make major mis­takes.

Two books on this sub­ject of bias­es and behav­ioral finance are “Think­ing, Fast and Slow” by Daniel Kah­ne­man, win­ner of the 2002 Nobel Prize in Eco­nom­ics, and “Mis­be­hav­ing: the Mak­ing of Behav­ioral Eco­nom­ics”, by Richard Thaler, win­ner of the Nobel Prize in Eco­nom­ics in 2017.

Behavioral Biases

There are many behav­ioral bias­es among investors, which include, but are not lim­it­ed to1, the fol­low­ing:

  • Con­ser­vatism, that is, the ten­den­cy to under­weight the impor­tance of new evi­dence that would not sup­port our vision. We often tend to be inter­est­ed and read about top­ics that sup­port our own order of things.
  • Greater atten­tion to sim­ple, but strong rea­son­ing that attracts atten­tion and is based on emo­tion. A sto­ry that is well told and touch­es the heart is much more like­ly to be accept­ed than cold, aca­d­e­m­ic rea­son­ing.
  • A poor under­stand­ing of prob­a­bil­i­ties and an overem­pha­sis on stereo­types. We are look­ing for expla­na­tions for things that don’t have any. We seek to deny ran­dom­ness.
  • Over­con­fi­dence. The vast major­i­ty of peo­ple feel bet­ter than the aver­age, most of us feel bet­ter than our col­leagues in our work, etc.
  • The attri­bu­tion of our fail­ures to bad luck and our suc­cess­es to our skill.
  • The “I knew it” bias. You always feel like you knew some­thing would hap­pen. The tech­no cri­sis? It was obvi­ous that all these com­pa­nies were over­val­ued…
  • Investors place more impor­tance on a loss than on a gain of the same mag­ni­tude. And when they are poten­tial­ly in a loss, they are will­ing to take absurd risks.
  • The “lot­tery tick­et” effect. We pre­fer a low prob­a­bil­i­ty of mak­ing a huge gain than high prob­a­bil­i­ties of mak­ing an aver­age gain… even know­ing that the weight­ed gain is bet­ter with small suc­cess­es.
  • Band­wag­on effect. The dif­fi­cul­ty in hav­ing one’s own judg­ment and the nat­ur­al ten­den­cy to do as the crowd does.
  • Anchor­ing, i. e. hold­ing on to a ref­er­ence num­ber. You have bought your house at such a price, so you can’t or won’t sell below it…

If you have done some invest­ing, you are prob­a­bly already aware of how these bias­es have affect­ed your deci­sion mak­ing.

One of the worst behav­ioral bias­es is to buy and sell at the worst pos­si­ble time

I will focus here on the recen­cy bias. This con­sists on rely­ing on recent events rather than on long trends. This push­es investors, as a whole, to invest at the worst pos­si­ble time. They invest when the mar­ket has gone up, and the chances of it con­tin­u­ing to go up have decreased. And, of course, they sell at the worst pos­si­ble time too.

We can find this bias in the cash flows of mutu­al funds. The graph below shows clear­ly that investors invest when the stock mar­ket has already risen. This graph 2 shows in blue a his­togram of the net flows of funds and in red the per­for­mance of the world stock mar­kets. We can observe, for exam­ple, that between 2008 and 2010, stock mar­kets fell and investors with­drew their mon­ey. If they had instead held, their patience would have been reward­ed hand­some­ly when the stock mar­ket went back up.

Behavioral biases have a very significant impact on investment performance.

Ilia D. Dichev, a pro­fes­sor at the Uni­ver­si­ty of Michi­gan, com­pared a “Buy and Hold” invest­ment, where one keeps assets for a long peri­od of time, and the real per­for­mance of investors, who go buy and sell assets as time goes. Buy and Hold wins every time. .

Morn­ingstar pub­lish “Mind the Gap” 3 annu­al­ly. This doc­u­ment is a ref­er­ence on the sub­ject of behav­ioral bias­es. We learn, for exam­ple, that over 10 years, investors in Amer­i­can funds invest­ing in the Unit­ed States lose 1% to 2% per year try­ing to “time” the mar­ket. They also showed that the more volatile an asset class or fund was, the more the investor lost to buy and hold.

In its 2005 study, we see that over 10 years, tech­nol­o­gy funds made 7.68% per year while investors who had invest­ed in these funds made ‑5.67%. This is a dif­fer­ence of more than 13% per year. In addi­tion, Morn­ingstar has shown that investors invest­ing in funds with the low­est fees are less affect­ed by mar­ket tim­ing (dif­fer­ence of 0.8% for the cheap­est quar­tile and 1.8% for the most expen­sive quar­tile.

Passive investment means planned investment, knowledge of oneself, the history of investment and its fundamentals

We must fight the nat­ur­al ten­den­cy to time the mar­ket

A good way to try to over­come it is through planned invest­ment. We invest every month (or every quar­ter) with­out ques­tion. This is the prin­ci­ple of pas­sive man­age­ment.

This works well with a peri­od­i­cal rebal­anc­ing of our port­fo­lio to match its planned allo­ca­tion. This allows to main­tain a con­stant risk pro­file and take advan­tage of oppor­tu­ni­ties, i.e: to buy when the mar­ket is down and to sell when the mar­ket is up.

This requires an obvi­ous strength of char­ac­ter. And if you think that you can do mar­ket tim­ing or that your mar­ket tim­ing is bet­ter than the aver­age investor, well,  for me that is over­con­fi­dence.

Automate your investments

To be less sub­ject to these behav­ioral bias­es, we must reduce the num­ber of deci­sions to be made and the num­ber of actions to be tak­en. This means, for exam­ple, mak­ing auto­mat­ic trans­fers. If pos­si­ble, we should have a bro­ker that does auto­mat­ic rebal­anc­ing. The auto­mat­ed aspect is a real asset for the investor who wants to free him­self from his mis­takes.

Fin­tech and in par­tic­u­lar robot advi­sors can help in this regard.

How­ev­er, the finan­cial advi­sor also has a role to play. Human advice is com­ple­men­tary to auto­mat­ic advice. Human advice can also help an investor to over­come his impuls­es, includ­ing buy­ing and sell­ing at the worst pos­si­ble time. He should be aware of behav­ioral finance, but he should also have an excel­lent knowl­edge of the mar­kets, their his­to­ry and the the­o­ries of invest­ment.

Investing alone is also possible

It’s empow­er­ing to take charge of your finan­cial life and it also saves on con­sult­ing fees. How­ev­er, it takes a great deal of strength of char­ac­ter to main­tain your plan at all costs. And I think that until you exper­i­ment with a stock mar­ket crash, you don’t real­ly know whether you can brave the storm.

More­over, some stud­ies have shown that accom­pa­nied investors can out­per­form unac­com­pa­nied ones. Their added val­ue can then exceed their cost. But in any case, whether by a robot or a human, an investor should be well accom­pa­nied.

Have you noticed these bias­es in your invest­ments? How did you over­come them? Do you use any kind of robot or human advi­sor?

Recommendation for investing successfully

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One of the coolest things about M1Finance is that they sup­port frac­tion­al shares. You don’t have to wor­ry about your mon­ey sit­ting idle in your account with­out being invest­ed. Every dol­lar you add will be allo­cat­ed. Final­ly, there are no man­age­ment or com­mis­sion fees, so every dol­lar you invest adds to your future wealth.

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  1. https://en.wikipedia.org/wiki/List_of_cognitive_biases
  2. https://www.ici.org/research/stats/factbook
  3. https://www.morningstar.com/lp/mind-the-gap

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2 Responses

  1. dan f says:

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    As for what asset asset allo­ca­tion to use — Paul Mer­ri­man’s web­site has a num­ber of dif­fer­ent “Best In Class” ETF rec­om­men­da­tions. His recent release of the “Ulti­mate Buy and Hold Port­fo­lio” for 2019 uses 10 ETFs to achieve a supe­ri­or risk-adjust­ed return sole­ly with wide­ly avail­able ETFs. Togeth­er with M1, Paul has cre­at­ed a set-it-and-for­get-it option that is the stuff dreams are made of for any DIY investor! We live in real­ly amaz­ing times where we have all these invest­ing options that are near­ly free.

    • Clarence says:

      Yeah, you got­ta love the lack of fees! TLH is not sup­port­ed but they have some­thing called “Tax-effi­cient invest­ing”. So when you with­draw mon­ey, they opti­mize what secu­ri­ties to sell to min­i­mize tax­es. In the end, you still get some tax advan­tages.

      After look­ing at his web­site, I think Paul Mer­ri­man’s port­fo­lios are fan­tas­tic for some­one look­ing for the ulti­mate buy-and-hold port­fo­lio. And if the process of main­tain­ing your asset allo­ca­tion can be auto­mat­ed, then it’s a no-brain­er.

      We do live in real­ly amaz­ing times!

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