VOICES FROM THE INDUSTRY: Investors often end up being their own worst enemies

May 15, 2006

In recent years, an increasing number of researchers, particularly in the field of psychology, have come to believe that investors undermine their investment and financial goals through such emotionally biased-even irrational-behaviors as overconfidence, a herd mentality, bias toward recent market results, and an excessive aversion to risk.

Eliminating such biases is difficult, but investors can mitigate their impact by following several time-tested investing and financial planning principles.

Think long term

Invest for the long term. Investing in riskier assets, such as stocks or real estate, should always be done for long-term goals: retirement, college, end-of-life gifts to heirs or charities. A rough rule of thumb might be that you shouldn't need that investment money any sooner than five years, and preferably 10 years or longer.

Investing for the long term can help thwart two common investing behavioral mistakes: recency bias and herd mentality.

Recency bias occurs because investors tend to focus on recent market patterns, whether positive or negative, and project those patterns into the future. It's one reason why they buy "hot" investments and shun "cold" ones-a tactic generally discredited by academic research.

By focusing on long-term goals, investors are less apt to be caught up in current market events.

Steady long-term investors are also less apt to follow the herd. Many investors, for example, jumped into high-tech stocks in 1998 and 1999 after seeing so many other investors buy them up-just in time to watch high-tech stocks plummet in 2000 and 2001.


Diversify. Another striking behavioral habit of investors is their overconfidence and excessive optimism. Princeton University professor Daniel Kahneman, who won a 2002 Nobel Prize for his studies of behavioral finance, notes how frequently investors exaggerate their skills.

Overconfidence about investing skills tends to lead to excessive trading. A study by two California professors of 60,000 households that traded stocks from 1991 to 1996 found that the average household underperformed the market by 3.7 percent each year, but those households that traded the most underperformed by more than 6 percent.

A follow-up study found that men traded 45 percent more than women and suffered lower risk-adjusted returns.

A well-diversified portfolio, developed from a well-crafted investment allocation policy that fits your long-term investing goals, can help reduce excessive trading, "overconfidence," and market "surprises" that often fool even investment professionals.

Periodic rebalancing of the portfolio also can keep these biases in check.

Look at the big picture. Investors tend to obsess on individual, short-term losses and gains-especially losses. They think "small," in Kahneman's words. The prospect of a loss so greatly outweighs the prospect of a gain of similar magnitude, say researchers, that investors become too conservative, thus undermining their long-term investment goals.

One study, for example, found that investors tend to sell off investment winners far more frequently than losers because they hate to realize losses, especially large ones. Yet the study found that the winners they sold generally went on to outperform the losers they'd kept by 3.5 percent the following year.

There's one exception to this loss aversion: faced with the choice between a sure loss and a small chance to break even, investors often gamble to break even.

Wise investors, on the other hand, worry little about individual gains and losses in their portfolio. That's because research has shown that even though specific investments or specific investment categories will suffer losses at any given time in a properly diversified portfolio, the overall portfolio performance may be positive over time.

Wise investors, in fact, understand that investing is only a part-though certainly a key part-of their overall financial picture. Building total wealth is what counts. This puts investing in its proper perspective and minimizes negative emotional biases that can undermine your goals.

Snyder is co-founder of Oaktree Financial Advisors in Carmel. Views expressed here are the writer's.
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