How Do Your Biases Impact Your Investments?


June 12, 2017

Who, me? Biased? If someone calls you biased in the wrong context, those can be fighting words. But the reality is we all have biases – including when it comes to investing. For example, have you heard about the hot-hand fallacy? How about herding or the optimism bias? Then surely you know about the disposition effect or recency bias. These are just a sampling of the behavioral biases that can come into play when you manage your own portfolio.

Let’s start by understanding what some of the most common biases are. The hot-hand fallacy (also called “hot-hand phenomenon” or “hot hand”) is the erroneous belief that a person who has experienced success with a random event has a greater chance of further success in additional attempts[1]. This is the same idea that if you’ve won the lottery, you have a better chance to win it again, or if you make the winning shot at the last second, you’re more likely to do that the next game. Unfortunately, having a hot hand is not always that easy, although things like practice, education, and diligence can certainly improve your investing methodology.

Herding is characterized by a lack of individual decision-making or thoughtfulness, causing people to think and act in the same way as the majority of those around them. In finance, a herd instinct describes how some individuals gravitate to the same or similar investments based almost solely on the fact that many others are investing in those stocks. The fear of regret or missing out on a good investment is often a driving force behind herd instinct[2]. Nobody wants to feel like they are missing out, so when it comes to investing, you might make a decision based on what friends or family members are doing. However, this decision may not factor in things like risk tolerances or time horizons that will vary significantly between individuals.

Normally, optimism is a good thing. But optimism bias in investing occurs when an individual’s subjective confidence in their judgment is greater than their objective accuracy. Many people tend to be overconfident in most areas of life. We are only correct about 80% of the time when we are “99% sure.”[3]  Dishearteningly, in a 2009 Josephson Institute survey on ethics, 92% students said they were of good character and 79% said that their character was better than most people – even though 27% of those same students admitted stealing from a store within the prior year and 60% said they had cheated on an exam[4].

All of the above behavioral biases, as well as a number of others, can result in emotional decision-making on investments. The effect of investors’ poor decision making has been illustrated in the following Dalbar study, which illustrates the available investment’s return, as compared to the average return of the individual in the same asset class:

Self Investor returns on equities (stocks) vs. S&P 500 index

Investment term Self Investor Returns S&P 500 Difference
30 year 3.7% 10.4% -6.7%
20 year 4.7% 8.2% -3.5%
10 Year 4.2% 7.3% -3.1%
5 Year 6.9% 12.6% -5.7%
3 Year 8.9% 15.1% -6.3%
1 Year -2.3% 1.4% -3.7%

Annualized rates of return. Source: DALBAR, as of December 2015

Self Investor returns on bonds vs. Barclays Aggregate bond index

Investment term Self Investor Returns Barclays Aggregate Difference
30 year 0.6% 6.7% -6.1%
20 year 0.5% 5.3% -4.8%
10 Year 0.4% 4.5% -4.2%
5 Year 0.1% 3.3% -3.2%
3 Year -1.8% 1.4% -3.2%
1 Year -3.1% 0.6% -3.7%

Annualized rates of return. Source: DALBAR, as of December 2015

Average equity investor, average bond investor and average asset allocation investor performance results are calculated using data supplied by the Investment Company Institute. Investor returns are represented by the change in total mutual fund assets after excluding sales, redemptions and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After calculating investor returns in dollar terms, two percentages are calculated for the period examined: Total investor return rate and annualized investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net of the sales, redemptions and exchanges for each period.

Enlisting the help of a professional, such as hiring an asset manager, can help to mitigate the risk of these behavioral biases. While hiring a private wealth manager does not guarantee better results than one would achieve on their own, there is certainly a case to be made for hiring a professional without an emotional attachment to your portfolio. In addition to removing emotion from investment decisions, hiring a private wealth manager may be a source of comfort if there are others, such as spouses or children, who rely on the health of the portfolio. It can be tempting to say, “I will just manage my portfolio until something happens to me; then I’ll turn over the reins to a professional once I can’t do it anymore.” But since we never know when death or incapacity might occur, It is prudent to have a plan in place, which may include hiring of a private wealth manager, before one of these events actually occurs.

The decision of whether to hire an investment professional or not is not one to be entered into lightly.  For most people, there will be a distinct advantage to using one. In many cases, investment advisor individuals/firms are fiduciaries, which have a more robust accountability to clients than that which is currently required of someone holding himself or herself out as a “financial advisor” – and is beholden to a suitability standard.  It’s important to evaluate the criteria most important to you. You might include things like track record, longevity of investment personnel with firm, fee structure, services offered, and whether there is a good fit philosophy-wise. Once you have hired a firm, a fair evaluation period is several years, or a market cycle. The marketplace for investment professionals is vast, so there is no need to settle if you are not satisfied.

Investment optionsThis report explores various investing options and some of their pros and cons. As your portfolio grows, options become available that may not have been when you first started investing. An investment plan and firm that worked for you when you were 30 may not be a good fit for you when you’re 50.

Download Investment Options Report

Investing involves risk, including risk of loss. Diversification does not ensure a profit or guarantee against loss. Past performance is no guarantee of future results.

The information provided herein is educational in nature, is not individualized, and is not intended to serve as the primary basis for your retirement, investment, or tax-planning decisions.

While AFAM has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability or completeness of third party information presented herein. The views and opinions expressed are subject to change at any time based upon market or other conditions and AFAM disclaims any responsibility to update such views.

Nothing presented herein is, or is intended to constitute, investment advice, nor sales material, and no investment decision should be made based on any information provided herein. Please consult your tax or financial advisor for additional information concerning your specific situation.

209-AFAM-6/26/2017

[1] Wikipedia
[2] Investopedia
[3] Kahneman, Daniel, Tversky, Amos. Choices, Values, and Frames. Cambridge University Press.

Josephson Institute of Ethics Releases Study on High School Character and Adult Conduct

October 29, 2009 – For immediate release Contact: Rich Jarc, Josephson Institute Executive Director rjarc@jiethics.org | 310-437-0827 The hole in the moral ozone seems to be getting bigger – each new generation is more likely to lie and cheat than the preceding one.


[4] http://josephsoninstitute.org/surveys/

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