Between 1997 and 2016 the S&P 500 had an average annual performance of 7.68% yet the average performance of an equity investor during that period was 4.79%. The biggest explanation of this underperformance is poor investor behavior and investor biases. Many individual investors attempt to outguess the market and end up buying and selling at inopportune times. However, healthy investor behavior with consistent and ongoing savings accounts for 87% of portfolio growth. The other 13% of portfolio growth is asset allocation and investment selection.
What is Behavioral Financial Advice?
Human beings are psychologically biased and many of these biases can impact financial decision-making. For example, we may be overconfident or we tend to make important decisions in an emotional state. Emotions can elicit a hasty response which may not be effective and in line with one’s goals. When we are unaware of our emotions, our decisions can go against our core values. The brain is hardwired to react before it reflects. An emotional response takes 12 milliseconds while a cognitive response takes 40. This is good if you are trying to escape a burning building, but it poses challenges if you are making financial decisions.
Behavioral financial advice attempts to address these issues by accounting for biases and emotions when making decisions. In this week’s post, we’re going to dig into 3 common behavioral biases that could negatively impact your investment returns.
Confirmation Bias
When you are making a decision, who do you talk to first for advice? We often choose to talk to people who tend to think like us. Confirmation bias is the tendency to accept evidence that confirms our beliefs and to reject evidence that contradicts them. Political views are a good example of this. We gravitate towards news channels, websites, and articles that have the same political views as us. We rarely listen to the opposing viewpoint or to evidence that might contradict our position. This is confirmation bias at work. Let’s say your investment philosophy is to invest solely in your company’s stock. In order to validate or “confirm” your beliefs, you may speak with a close colleague at your company who follows the same investment philosophy. You may have heard that it is generally better to diversify, but your own internal filters silence that thought. Confirmation bias leads to a narrow frame of decision-making.
Recency & Herd Mentality
With news headlines warning (speculating) of an impending recession, it’s hard not to wonder how this will affect your investment portfolio. Recency bias convinces us that news happening in the present is the most important. Investors tend to base their expectations on how the market has been performing recently. Therefore, if the stock market’s recent performance has been weak, many expect these same poor returns to continue, pretty much along a linear path into the future. Or similarly, investors may base past performance of a mutual fund manager and expect that same performance to continue. However, research shows that most funds in the top quartile (25%) of previous five-year returns did not maintain a top-quartile ranking in the following five years. In other words, past performance offers little insight into the future.
An investor that falls victim to recency bias is likely to be affected by herd mentality as well. Herd mentality is acting on news happening now and then making drastic changes based on what the masses are doing i.e. acting largely on emotions versus rational thoughts. This bias was especially seen in the most recent recession. In 2008, the stock market suffered substantial losses of up to 40%. Many investors sold and abandoned the markets altogether. Of course, the market rebounded from that time forward. No one has a crystal ball on how the future will turn out. The best we can do is focus on what we can control. It takes perseverance and determination to tune out the noise.
Overconfidence Bias
An overconfident investor believes they can outperform the market through their own research, stock picking, or timing. However, the reality is, overconfident investors underperform the market by chasing past performance. The markets are an efficient pricing machine. During 2018, a daily average of $462.8 billion in equity trading took place around the world. The combined effect of all this buying and selling is that information is quickly incorporated into prices. Trying to time the market or pick stocks based on an article on your newsfeed or a segment from financial television? It’s highly likely that the specific information is already reflected in prices by the time you can react to it. Professor Robert Merton, a Nobel Laureate, stated, “Timing markets is the dream of everybody. Suppose I could verify that I’m a .700 hitter in calling market turns. That’s pretty good; you’d hire me right away. But to be a good market timer, you’ve got to do it twice. What if the chances of me getting it right were independent each time? They’re not. But if they were, that’s 0.7 times 0.7. That’s less than 50-50. So, market timing is horribly difficult to do.” We might get lucky and outperform the market once or maybe twice, but we are not going to consistently outperform the market over time. Consistently outperforming the marketplace over time implies that we are able to predict the future.
The Bottom Line
Investments tend to outperform investors. However, it doesn’t have to be that way. By managing your behaviors and understanding your biases, you can capture market returns. The sooner you can let go of the thought of reacting to headlines, stock picking, or timing, the better off you and your financial plan will be. Long-term wealth is built from healthy investment and savings behavior not from falling victim to your biases.
What does a Behavioral Financial Advisor (BFA™) do?
While the CFP® curriculum focuses largely on the important technical aspects of financial planning, a BFA™ helps clients address their specific psychological biases. Through ongoing coaching and educating, a Behavioral Financial Advisor helps clients make rational financial decisions in the presence of competing emotions. For comprehensive financial planning, both the technical planning and the behavioral elements are important for helping a client accomplish their goals.
If you’re looking for holistic planning along with personal coaching from a CFP® and BFA™ professional in Seattle, schedule a free consultation today!
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