Human emotion has been shown to be the Achilles Heel of most investors as Charles Munger, long-time partner of Warren Buffet, once said, “A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. You need to keep raw, irrational emotion under control.” Behavioral finance, the study of the influence of psychology on the behavior of investors, has sought to answer why investors are generally their own worst enemy and ways to combat this weakness.
Behavioral finance highlights the fact that investors do not always act rationally (i.e. logic based decisions), are overly influenced by personal biases, and at critical times show an inability to control their emotions, resulting in poor investment decisions. Since 1994, Dalbar, Inc. (“Dalbar”) has measured the effects of the “average investor” and their decisions to buy, sell, and switch into and out of investments over various periods of time. Dalbar utilizes the net aggregate mutual fund sales, redemptions, and exchanges each month as a measure of investor behavior. According to Dalbar, the “average investor” for the 20 year period ending December 31, 2018, earned 1.9% per year relative to the S&P 500 Index up 5.6% and Barclays Aggregate Bond Index up 4.5% over the same time period.
The significant underperformance of the “average investor” compared to an aggressive, 100% domestic equity portfolio and a conservative, 100% taxable bond portfolio over a 20 year period illustrates the tremendous impact investor decision making has on long-term performance regardless of investor risk tolerance.
Behavioral finance has identified several investor biases. A few investor biases that we typically encounter when working with clients and prospective clients include:
Mental Accounting - the classification of funds into different buckets leading to irrational personal finance decisions. A common mental accounting example occurs when an individual is saving money in a low-interest savings account earmarked for a future vacation while also carrying a large credit card balance at a higher interest rate. Instead of funneling money to pay down high-interest debt faster, investors view the vacation fund as a different bucket of money.
Herd Mentality - the tendency for investors to follow the crowd. Investors following the herd are largely influenced by emotion and instinct rather than independent analysis. As humans we are hard wired to follow the herd. In fact, studies have shown that for some individuals going against the crowd or being a contrarian investor causes them physical and mental discomfort. Herd mentality is exhibited when an investor buys a stock because it is “hot” or they received a stock tip from a friend without doing any analysis to confirm the underlying merits of the investment.
Hindsight Bias - the misconception that outcomes are obvious after the fact. The real estate crash of the late 2000s resulting from thousands of Americans purchasing homes that they realistically could not afford or the dotcom bust of the late 1990s fueled by speculative investing in unprofitable internet-based companies, in retrospect, were bad periods to invest. But if we examine history, the investment professionals that noted these now apparent issues were either laughed at or altogether ignored in the moment.
Loss Aversion - the tendency to overly focus on the potential for, or avoidance of, a loss more so than generating investment gains. Research has discovered that investors feel the pain of a loss more than twice as strongly as they feel the enjoyment of a making a profit. A person investing in low-return, guaranteed investments despite their ability and financial wherewithal to invest in more promising, higher risk investments is an example of loss aversion.
When making decisions, a human being’s default option is to trust our gut, making us more susceptible to undue influence from personal biases and emotions as well as other social influences. If left unchecked, investor biases illustrate the negative impact one’s emotions can have on long-term investment performance.
Now that we have identified the potential negative impact that personal biases can have on long-term investment performance, how do we guard against these investor pitfalls?
As often as possible, we try to instill a fact-based, logical investment process to remove the emotional element of investing. This is where working with a competent financial advisor to develop a comprehensive plan is a great first step to removing investor emotion from the equation. This comprehensive financial plan seeks to lay out the key financial inputs (i.e. income, spending, retirement age, etc.) to an individual’s long-term financial picture allowing them to assess future considerations in a fact-based, logical manner.
Once the big picture financial plan has been constructed, we work with clients to establish long-term investment allocation targets. These long-term portfolio targets are key as they significantly reduce the emotional component when investing money. The adherence to long-term investment targets encourages investors to act rationally during any capital market environment as we are consistently applying a logical assessment of our current positioning relative to those targets.
Behavioral finance has illustrated that investors have a tendency to make poor investment decisions because of personal biases and emotions resulting in sub-optimal investment performance. However, investors can more than overcome any personal shortfalls via a structured, comprehensive financial plan with long-term investment targets encouraging a repeatable, logical process for making sound long-term financial decisions.
Schneider Downs Wealth Management Advisors, LP (SDWMA) is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). SDWMA provides fee-based investment management services and financial planning services, along with fee-based retirement advisory and consulting services. Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.