One of the greatest downfalls to an investment portfolio is the human who owns it. We all know that the best way to ensure your assets grow is to "Buy low; Sell high". So why are we still struggling to see decent returns over the long run?
Feelings.
Humans get quite emotional over their money and investing. Most of time, emotions influence our investing decisions and hinders our returns. Below is a chart/study done by Dalbar and published by Blackrock showing the average investor returns. The under performance in large part is due to investor behavior caused by emotions:
The average investor returned 2.11% betwen 1996-2015 which under performed other asset classes and inflation
Behavioral Finance
What causes this under-performance for the average investor? Emotions and psychology cause poor investing decisions. Behavioral finance is the study of how behavior and psychology explain why people make bad financial decisions.
Here are some main concepts in Behavioral Finance:
Anchoring
Anchoring is our tendency to attach our thoughts on a reference point - even if it isn't relevant to the decision at hand. An example is in our perception of the Canadian-US dollar exchange rate. Currently at time of writing it is at $0.75 US to $1 CDN. I've talked to a few people that are postponing taking vacation in the US or buying US investments since the 'Canadian Dollar is low". Yes it is low compared to when the dollar was at par, but that was in 2013 and completely irrelevant to the economic circumstances of the present. The dollar could go lower or higher, no one knows, so basing decisions on the fact that the CDN$ was at par in 2013 and is therefore 'low' is an example of anchoring.
Hindsight Bias and Overconfidence
Hindsight bias is looking back and thinking that past events were obvious or predictable. For example, looking back at the Tech bubble burst in the late 1990s and thinking how obvious it was. Often hindsight bias creates a level of overconfidence in our own abilities and our ability to predict future investments. People think of themselves as superior stock pickers and believe that they have an above level of investing talent. Those that are overconfident tend to be those that also 'forget' about the losses they've had and only focus on when they were correct with the 'winners'.
Herd Behavior
Herd behavior is following what everyone else is doing. This can be because we feel everyone else must be doing something right (if enough people are doing it) or because we want to fit in socially. In investing, we have the tendency to look to see what the trend is and follow it without thinking whether it is the best for us or the most reasonable. Chances are also that is you are a late comer to what everyone else is already doing, you have already missed out on the opportunity.
Prospect Theory
Prospect theory is essentially our irrational outlook on losses vs gains. There have been many studies that show that an investment loss hurts way more than an equivalent investment gain. This is reflected for investors in the 'Disposition Effect' where investors tend not to be able to sell out of a loss position and are too soon to sell in a gain position. Also, this loss aversion trait can lead to portfolios that are too safe and do not provide the growth required or necessary to achieve one's long term goals.
Recency Bias and Availability Bias
Often we hear about the latest stock tip or what's on the news about the markets. This can cause us to over value and over react to new information. All this information is really just 'noise' as it's usually incomplete information or biased information. Sensational news/media plays a hand into feeding the emotions of investors causing poor decisions to be made.
Mental Accounting
Mental accounting is the tendency to separate our money into different 'buckets' and thus valuing and treating them differently depending on the source or intended use. An example of mental accounting is if you have high interest debts outstanding yet you allocate money to debts that are lower interest, like a mortgage, or put into a savings fund earning very little interest. An example of mental accounting in investing is having a 'safe' account of investments and a 'risky' or 'speculative' account. In reality, whether you treat your money in one account differently than another makes no difference to the cumulative effect on your household finances.
Gambler's Fallacy
This is when we believe that a prior series of events will predict the next result. Just because a stock went up six consecutive sessions does not mean that it will go down on the seventh. The seventh session is independent and unrelated to previous sessions. Too often investor behavior follows gambler's fallacy by thinking that certain stocks or assets are 'undervalued' compared to historical prices or trends.
Solution
The point of this article is to highlight how bad we are with money based on irrational emotional behaviors. The solution is to take as much of the emotion out of money and investing as possible. You need to set up systems and train yourself to be unemotional to money decisions. One way to do this is to create a Passive portfolio that follows a strict asset allocation and re-balancing schedule, or to utilize a Robo-advisor that will do it for you. By doing so with a rules based system, you take the emotion out of investing and thus increase your chances of success. One major added benefit of trying to build a system to eliminate emotion is that you can ignore/drown out the 'noise' of 'hot tips', or 'market fluctuations' that you hear from the news or others. What other people say and what happens on the markets will no longer be a point of stress with a sound re-balancing strategy that reduces our emotional impact on our investments.