Mar 15, 2013

Behavioral Finance – On Your Best Behavior

Behavioral finance has become a focus for many academics in recent years. In fact, numerous colleges and universities are offering coursework on the study of human behavior in relation to money. It has grown in popularity due to the increasing discrepancy between investment returns and investor returns. Countless studies have pointed to investors earning less than one-third of the performance of the broad stock markets. The average investor makes a series of mistakes that translates to far worse performance than simply buying the 500 largest companies in the U.S. These mistakes led Utah-based financial planner Carl Richards to write a book in 2012 titled, The Behavior Gap. He dubbed the “behavior gap” as the gap between what we should do with money and what we actually do with money. It boils down to far more than investments, but we thought it was worth-while to focus on five common mistakes investors make. We will also address what you can do to avoid these common investment mistakes. The following list was interpreted from an article by Robert Seawright, Chief Investment & Information Officer of Madison Avenue Securities.

1. Loss Aversion

Studies show that humans respond to losses at least twice as strongly than their reaction to portfolio gains. A loss of $100 tends to feel psychologically worse than the positive feeling of earning $100. As a result of this, the average investor is far more cognizant of potential risk than potential return.

Focus on Process

Investment strategies are only consistently effective when they are part of a well-constructed, careful, clearly defined process. Rather than making investment decisions based on “feelings” or anecdotal evidence, understand the historical risk and return relationship.

2. Confirmation Bias

Instead of carefully gathering data and evaluating facts to reach a conclusion, many investors reach a conclusion first. This is known as a pre-conceived conclusion. This can happen in other realms of life too, such as politics or philosophy. Once a conclusion is drawn, we then do the research to support the conclusion, which is obviously backwards and cripples investment decisions.

Actively Seek Out Contrary Data and Conclusions

Pre-existing beliefs skew decision-making in a way that leads to many other investment mistakes (see Herding and Recency Bias). The most successful investors in our history have been ones who went against the popular opinion, challenged common investment theory, and were willing to have conviction in the data or research before a conviction in a conclusion.

3. The Planning Fallacy

Over estimating our own capacity to shape the future leads us on a path of unmet expectations and undesired conse-quences. More specifically, we undervalue the time and effort necessary to complete a task, project, or goal. This is the downfall of most unsuccessful financial plans. Most workers looking to retire soon have under-saved, under-invested, and misjudged the age they can retire.

Test and Re-Test

Financial planning is an evolving process, and should never be considered a one-time event. As assumptions change, life transpires, and goals transform; your financial plan should be revisited and revised. This will involve re-testing assumptions and oftentimes adjusting your process.

4. Herding

Herding is the practice of following the crowd. Ignoring the crowd is difficult, and it always “feels” better to be wrong along with everyone else than be wrong all by yourself. In most cases, herding leads to buying the “next hot stock” and chasing performance.

Avoid the Noise

In a world with unlimited access to information, you have the right to discriminate the information that reaches your brain. We always suggest limiting access to daily market commen-tary and the financial press. In the words of Warren Buffett, “You are neither right nor wrong because the crowd dis-agrees with you. You are right because your data and reason-ing are right.”

5. Recency Bias

Recent events impact our outlook for the future despite mounting evidence that nothing lasts forever. In terms of investing, even astute investors tend to overweight sectors of the market that have performed very well in the last year or two. Similarly, as seen in 2009 and 2010 as the stock market was recovering from the crash, investors withdrew money from stocks at a record pace because they were certain of a “double-dip recession” and 2008 happening all over again.

Focus on the Data

Even though stocks have averaged between 8% and 10% a year, they have temporarily declined 14% each year along the way. Temporary declines are normal, and we should plan on them occurring. Your plan should account for money needed in short, intermediate, and long-time horizons, and each time frame calls for a different investment objective.

If we are aware of these potential mistakes, we can focus on the ways to avoid them. One of the most important values we can provide to our clients is attempting to circumvent these mistakes through learning and education. Even the most sophisticated