Are Your Biases Taking a Bite out of Your Returns?

February 10, 2016

fb-biasesbiteMost serious investors spend a fair bit of time considering and selecting their investments.

They think about which funds to own, and how a fund might fit into their portfolios.

They follow market behavior and consider how it might affect their portfolios.

But few investors take the time to truly study themselves, and how we behave as investors can have a major impact on our returns.

The field of behavioral finance investigates how our emotions and our biases affect our investment decisions and cause us to act in ways that aren’t in our best interests.

Although most of us think that we’re making informed investment decisions based on facts, we are likely more biased than we realize.

And because these biases are often unconscious, we may not realize the insidious ways that they’re affecting our investments and holding us back from achieving our long-term goals.

When we talk with investors, these are the four common biases that tend to come up:

1. Confirmation bias may seem scientific, but it can distort your perspective

“I’m out of the market because I think we’re headed for a bear market,” an investor said recently.

This investor may be under the influence of confirmation bias, a tendency to seek out information that supports what we already believe.

If you believe that the market will continue to fall, then you’re more apt to focus on the pundits who say the bull market has gone on too long.

And if you think that the market will continue to push higher, you’re likely to give more credit to those who say the bull market still has room to run.

Confirmation bias is one of the most common and persistent investor biases, in part because it can look scientific. We believe we’re gathering data and reading expert opinions and assessing it objectively, but we’re often unconsciously favoring the data and the opinions that we already agree with.

Confirmation bias taps into our desire to believe that there’s some person or some data point that can help us know what the future will bring. But the reality is that no one has a crystal ball. No one knows how long the bull market will last.

What to do: Instead of trying to predict what will happen in the future, we believe investors are better off relying on a disciplined investment strategy that can help them know where to invest now and what to do when markets inevitably change.

Even if you think that technology is the best place to invest (and you’ve read plenty of studies that confirm the strong growth potential of technology), your strategy should help you determine if this is a good time to invest in technology, and if exposure to a single sector like tech is consistent with your risk tolerance and investment goals.

2. Anchoring can limit your perspective–and your returns

“I bought into emerging markets last year and now I’m waiting for these funds to get back to the price I paid for them,” this investor told me.

This is a form of anchoring, our tendency to get attached or ‘anchored’ to a particular piece of information when making investment decisions. If we anchor on the price we initially paid for a fund, we could end up holding lagging funds for years, while other funds are bringing in good returns.

What to do: We can work to counter the effects of anchoring by consider a wide range of possible investments. If we’re only focused on the performance of one fund, we may not realize that other funds are doing better.

When we make investment decisions, we compare funds to other funds with similar risk. We look at U.S. funds and foreign funds, growth and value funds, and small- and large-cap funds (and we share this data in every monthly issue of NoLoad FundX).

Our Upgrading strategy also helps us know when it’s time to sell a fund–regardless of the price we initially bought it for. It leads us to take action based on what is currently happening in the stock and bond markets, not on what might happen in the future.

3. Focusing on the worst-case scenario can derail your portfolio

“I can’t handle another 2008, so I steer clear of stocks,” a caller told us. She’s spent the last seven years holding short-term bonds and cash.

The 2008-2009 declines made many investors wary of stocks, but focusing on the worst case scenario rather than the most likely outcome is an example of probability neglect. This powerful bias can make us overly concerned about events that are rare, but dramatic and memorable, and it can lead us to act in ways that aren’t in our best interest.

Severe market declines of 50-60%, for example, have been rare. Historically, the market has suffered 50%-60% declines about every 50 years. A twice-a-century event makes headlines—it even makes history—but it’s far more likely that markets will experience more modest pullbacks. Sell-offs of 5-10% are quite common. The S&P 500 index has averaged three 5% pullbacks and one 10% decline about every twelve months.

Probability neglect makes us feel like we are wisely preparing ourselves for potential dangers, but focusing on our biggest fears can distort our perspective. It can make us see the stock market as a way to lose wealth rather than a way to build wealth. Markets do experience declines over time, but investors who have owned stocks for 20 years or more have been well rewarded. Stocks have been positive over every rolling 20-year period back to 1950.

Focusing on the worst-case investing scenario can also make us more risk-averse than necessary. The caller we spoke with who has avoided stocks for years has missed out terrific gains during the market’s recovery and probably lost money to inflation.

What to do: If you’ve been investing based on the worst-possible outcome, take a step back and consider whether your fears are probable- not just if they are possible. It can help to put your assumptions in a larger context–perhaps by considering how often declines occur, or focusing on the long-term returns of stocks and bonds.

4. Too much confidence can be hazardous to your wealth

“I’m not worried about risk,” an investor told us. “I got out of the market in early 2008 and avoided those losses, and I’ll do it again before the next bear market.”

This is a good example of overconfidence, our tendency to believe we’re more skilled than we actually are. We think that because we got it right once that we’ll always get it right. “Because we’re human, we’re really good at taking a prior success and projecting it into the future,” financial writer Carl Richards wrote. “The end result is an unwarranted, and unhealthy, belief that somehow we’ll come out on top again. We usually fail to take into account all the things that led to our last success.”

Overconfidence can lead to mistakes. If we think that we’ll be able to avoid all market declines, for example, we may take excessive risk. We might focus only on sector funds, even though diversified funds are most appropriate for our growth portfolios, or we may not recognize the value of owning bonds, which can be a buffer against stock market declines.

Rather than thinking we’ll always come out on top, we believe that investors should rely on a proven way to manage risk and return, and a balanced portfolio that includes both stocks for growth and bonds to help buffer the volatility of stocks is a good place to start.

This post by FundX President Janet Brown initially appeared on Forbes.

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