Psychology and Investing – Common Behavioral Biases

Tuesday, March 23, 2010   

Legendary investor Benjamin Graham said, “The investor’s chief problem – and even his worst enemy – is likely to be himself.”  After decades of research on individual investor behavior, few would argue with Mr. Graham’s hypothesis.  When unchecked, the same natural human tendencies that allow us to function, and even succeed, in our daily lives, can wreak havoc on our investment portfolios.  In order to successfully defend against these harmful behavioral biases, we must first take the time to understand them better. 

Overconfidence.  70% of Americans believe that they are smarter than the average American.  Obviously, a lot of us are wrong.  Despite acting as a positive force in some areas of life (e.g., entrepreneurship), overconfidence in one’s ability to beat the market leads to frequent trading, higher expenses and poor performance.  Overconfidence can be a product of other psychological tendencies, such as hindsight bias (concluding, after the fact, that an event was predictable) and self-attribution (taking personal credit for successes, while blaming failures on outside forces). 

Loss Aversion.  This phenomenon causes us to feel more pain from a $1000 loss than we feel happiness from a $1000 gain.  As a result, we tend to hold losing investments for too long (in order to avoid the pain associated with realizing the loss) and sell winning investments too soon.  Both of these practices destroy investment returns. 

Herding.  Most humans have a natural desire to conform socially.  Finding safety in numbers, we deem it unlikely that a very large group of people could be wrong about anything, including an investment.  The momentum generated by herd behavior is often blamed for investing bubbles.  On an individual level, herding is so damaging because it can cause an investor to buy at the worst possible time (the top of the market) and sell at the worst possible time (the bottom).

Familiarity.  Humans tend to find comfort in the familiar, and investing is no exception.  Familiarity is dangerous because it can foster the illusion of control.  When investors focus on trading securities within a familiar geographical location or sector, presumably because their expertise could enhance returns, the result is decreased portfolio diversification and higher-than-expected volatility.

Anchoring.  When making decisions, we have a tendency to place too much importance on an incomplete or irrelevant piece of data, such as a recent stock price.  For example, many investors assume, without any additional analysis, that if a stock trades consistently at $100/share, and then suddenly drops to $50/share, it must be undervalued.

Dalbar’s 2009 version of its Quantitative Analysis of Investor Behavior study found that over the past 20 years, the average US equity investor underperformed the S&P 500 index by a whopping 6.5% annually!  This underperformance resulted primarily from misguided attempts to time the market (buying high and selling low), behavior that was influenced by many of the biases that we’ve explored today.  In order to be successful, do-it-yourself investors must systematically shield their portfolios from these harmful tendencies.  Next time, I’ll tell you how to do just that.

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Posted by George | DIY Investing | Comments (0)

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