As trusted advisors, our job is to help people make informed and smart choices. To do that, we have to explore and understand behavioral biases. In the podcast I mentioned last week, Dr. Daniel Kahneman summarizes the cognitive biases that affect our everyday lives and our investing outcomes. Our task is to make that connection clear for clients and ensure they don’t fall victim to behavior that hurts their portfolio’s performance.
Kahneman’s worry about attribute substitution — when an individual makes a judgment that is computationally complex, but substitutes a more easily calculated heuristic attribute — often leads to a false sense of confidence in investors. That is, if you believe you understand a complex market, you are more likely to feel you have control over the market and the ability to pick winners. If that investment does go down, often the overconfident investor is unable to accept failure and hangs onto the losing investment, hoping it will bounce back when the market comes to its senses. Overconfidence can develop into myopia where an investor loses the ability to view the investment objectively as one part of a total portfolio. Our job is to keep clients appropriately focus on the big picture.
The mental shortcuts Kahneman warns of lead to a similarly harmful behavior — simplification. Investors often claim to see patterns in random events, such as stock price movements, and make decisions based on these false patterns. Of course, one look at the Callan Periodic Table of Investment Returns shows that there is no pattern to the performance of asset classes. Additionally, to keep it simple, investors gravitate toward the familiar. Studies show that folks prefer investing in local companies. However, those personal attachments that make it easier to make an investment decision also make it difficult for investors to conduct an accurate and objective initial evaluation or to analyze new information. In our view, investing in broadly diversified asset class funds rather than loading up on individual stocks can temper this risk.
Also important to overcome is loss aversion which refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains. This fear can prevent someone from investing for the long-term. A volatile market could offer the best prospect for long-term growth. And the more beneficial portfolio decisions come when we look at performance over the arc of time, not on a weekly or monthly basis.
Following an investment policy statement allows one to follow a rational investment plan and avoid investing on emotion, rumor and other psychological biases. If you want to overcome these psychological investment biases, concentrate on what you can control in the investment environment: How much you invest, where you invest, whether you use low cost funds, whether you use tax-efficient funds, etc. Finally, limit the activities that magnify your psychological biases. That means not checking your portfolio every day, or even every week. Review your properly allocated diversified portfolio on a preset schedule and compare performance to your own personal goals.