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.
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?
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The Oracle of FI is a middle-class guy working as a software developer. His goal is to achieve full financial independence by the age of 40.
He started this blog in 2019 in order to share his tips and techniques on investing, saving money and making the most out of life.
He has a cat and lives in France.