“The investor’s chief problem – and even his worst enemy – is likely to be himself.” - Benjamin Graham, mentor to Warren Buffet
What’s the worst investment mistake you’ve ever made? Bought high and sold low? Chased performance by purchasing the stocks that did well LAST year? Invested in Uncle Norm’s “business opportunity” because he’s family and how could you say no?
My personal worst was making an investment in an unproven startup with no cash flows or assets - just an idea. High returns were promised, but the company was unable to get off the ground and later filed bankruptcy (I lost the entire sum of money I invested).
Regardless of what your worst investment mistake has been, you made the mistake because you’re human – and humans are naturally wired to be terrible investors. Think about it…more often than not, our brain tells us to seek comfort and to avoid pain. While that type of tendency has helped us survive since the Stone Age, it's also a vital reason why we inevitably struggle to consistently make sound investment decisions.
Understanding how our mind can help or hinder our chances of investment success is critically important for every investor. Unfortunately, mounting research suggests our mind hinders our chances of investment success significantly more than it helps. In fact, there are over 115 different human biases that can prevent us from making rational investment decisions.1
We know human biases exist and can affect our investment returns, but can we quantify their oftentimes adverse consequences? DALBAR, a financial services market research firm, releases what they call a “Quantitative Analysis of Investor Behavior” report each year that measures how investors’ decisions affected their long-term performance. The chart below quantifies the cost of poor behavioral decisions for the average investor.
Over a 20-year time period, the average balanced-fund investor experienced an annual rate of return 4.2% lower than investors who stayed the course without making changes to their balanced portfolio. Based on an initial investment of $100,000, excluding fees, this would add up to a difference of $206,059 over 20 years.
This data probably doesn’t apply to you though, right? While the majority of us believe there’s no way we could be in the middle of the pack, that’s not exactly how the law of averages works. In fact, cognitive biases like illusory superiority and overconfidence could fool you into thinking your returns and skill are vastly superior to the average investor.
If we take a step back from the emotions of investing and look at our behavior from a high level, we quickly realize how irrational we tend to become under the influence of our own biases. For example, have you ever heard of a store where the merchandise goes on sale and instead of using the discounted prices as a buying opportunity, the customers instead decide to run out of the store?
When we experience short-term, downward market volatility, the stock market becomes that store. Why? We’re wired to act in situations like this, but the market tends to reward inaction. An emotional bias known as loss aversion suggests we tend to feel pain more intensely than the joy of an equivalent gain.2 Loss aversion often manifests itself during times of stress and helps explain why investors sell shares following market declines.
On the flip side, can you imagine purchasing a business simply because the price of the business had been marked up substantially last week and the week prior? Me neither, but it happens all the time! Investors who decide to buy when the market has experienced recent gains are likely influenced by herd mentality, another behavioral bias interfering with our decision-making process.
While we will likely never find a “cure” for behavioral biases, here are three things we can do to increase our odds as successful investors:
1. Worry about controlling the things you can control.
Rather than worrying which way the market is going to go next week or what’s going to happen to interest rates next year, focus on your behavior, minimizing fees & expenses, and maintaining appropriate diversification.
2. Be intellectually honest with yourself.
The most successful investors aren’t devoid of behavioral biases, but rather possess a certain level of intellectual honesty with themselves. By understanding and recognizing their own biases, they increase their odds of overcoming some of the emotional decisions that often lead to investment mistakes.
3. Have a plan.
It’s natural for investors to feel anxious during market declines. Having a strict, rules-based system you can follow during times of volatility can help make your decisions data driven and informed rather than emotional and on a whim.
Before making investment-related decisions, consider what biases may be at work beneath your conscious radar. Whether you’re a personal investor, an investment manager, a financial planner, or anyone else, you can benefit from understanding the internal driving forces behind your investment decisions.
1. Crosby, Daniel. The Behavioral Investor. Great Britain: Harriman House, 2018. Print
2. Kahneman & Tversky, 1979