Behavioral Biases and Their Potential Impact on Investing
By Sloan Smith, CAIA, MBA, CPWA® | Principal
After having benefitted from the longest economic expansion since World War II, investors may face greater volatility and potentially lower returns in the coming years. Global equity valuations are trading at or slightly above historical averages, global economic growth is slowing, trade tensions are continuing and geopolitical uncertainties seem to be increasing. During these times it is important to remain disciplined, focused on long-term goals and resilient, especially during short-term market swings. Unfortunately, built-in biases in human behavior can lead individuals to make illogical and often irrational choices. Developing a greater understanding of these behavioral biases and putting appropriate guidelines in place can help investors avoid making poor emotional decisions and improve their long-term investment returns.
In 2019, Cerulli Associates surveyed more than 300 investment advisors to understand the most prevalent behavioral biases impacting their clients. (1) The study identified the five most prominent biases as recency bias, loss aversion, confirmation bias, familiarity/home bias and anchoring bias. While each bias is unique, all of them have the potential to hinder long-term investment results.
1. Recency Bias
Recency bias was found to be the most common investing bias. In this case, individuals tend to focus on the importance of recent events. Believing that future results will be driven by the latest trends usually leads to investors making poor decisions. For example, recency bias can cause investors to buy a popular investment idea or sell a position after an immediate market downturn while completely ignoring their strategic asset allocation. Ultimately, expecting past trends to continue indefinitely will most likely lead to disappointing outcomes. It is important that investors comprehend any unrealistic expectations and maintain focus on their long-term return objectives, risk tolerance and a prudent and diversified financial plan.
2. Loss Aversion
Loss aversion is the inclination to avoid losses. This behavior can cause investors to hold losing investments too long or sell winners too early. Also, it can lead to individuals taking on more risk than they may be able to accept while also holding unbalanced portfolios. These tendencies usually lead to illogical behavior which can hinder performance substantially. For example, after the recession in 2008, if an individual sold all their securities due to a significant market decline then they would have missed the upside of the market recovery. This bias can be minimized by individuals checking their portfolio values less frequently and having discussions with their investment advisor especially during volatile times. These actions should lead to less emotional reactions and more sensible decisions.
3. Confirmation Bias
Confirmation bias is the inclination to seek out only information that strengthens one’s beliefs, while disregarding potentially conflicting material. This behavior can lead to individuals only listening to evidence that supports their views and discounting any opposing opinions. These actions can result in investors holding onto or overconcentrating their portfolio in a single position or asset class. In order to avoid this bias, it is essential that investors not only understand differing viewpoints, but also see how these biases could negatively affect their asset allocation and long-term goals.
4. Familiarity/Home Bias
Familiarity bias occurs when people make decisions based on their own experiences. Familiarity biases are usually displayed by owning a concentrated exposure in a particular stock or only investing in companies domiciled in the United States. This behavior can lead to undiversified portfolios that are heavily weighted to domestic companies and the U.S. economic cycle. These tendencies can be prevented by further understanding the benefits of diversification across different asset classes and geographies.
5. Anchoring Bias
Anchoring bias is the tendency to focus on a specific reference point when making decisions. (2) For example, an investor may concentrate solely on the price they paid for a position or security when evaluating its merits, even though that price does not relate to the holding’s long-term fundamentals. Also, the bias leads to clients comparing their portfolio’s performance against a single, generic benchmark (i.e. S&P 500), which may not align with their asset allocation, return objective and risk tolerance. The most effective way to diminish this bias is to associate the performance of the portfolio relative to a future goal, rather than a certain price or benchmark.
It may be difficult for investors to eliminate all of these behavioral biases. However, there are ways minimize the negative impact that these issues could have on a portfolio. At Innovest, our proven process helps clients mitigate common biases to achieve their long-term goals. Our proven approach includes having a long-term view, focusing on a goals-based plan and periodic portfolio rebalancing. During times of volatility, we help our clients understand their return target and risk tolerance and follow a financial plan that can help reduce behavior biases. Also, periodic rebalancing and these other methods can take emotional decision-making out of the investment process. Ultimately, it is important that investors recognize these biases and work with their investment advisor to formulate a strategy to reduce these tendencies while remaining focused on the long-term objectives of their portfolio.
Figure 1 (See Reference Below) (3)
Figure 2 (See Reference Below) (4)
References
1 Cheses, Asher “The Role of Behavioral Finance in Advising Clients”
2 Ibid
3 Ibid
4 Ibid