Understanding Investor Biases: A Key to Sound Long Term Investing
Often times in our investment meetings with clients, we discuss the emotional and behavioral challenges investors face. This is especially true today in the world of 24/7 (always) “breaking” news coverage. It seems that every day there is a major issue that should somehow cause us to temporarily alter our long term investment strategy. As advisors, we believe that an important role we serve is to help educate our clients to help them separate important issues impacting their investment strategy from those many emotional and behavioral issues that have no bearing on the long term. With that in mind, we would like to introduce you to several behavioral biases that can occasionally challenge investor’s (and advisor’s) long-term perspective. Short Term Focus: Inappropriately focusing on short-term risk (volatility) versus long-term risk (inflation/loss of purchasing power).Successful investors have the ability to ignore or endure portfolio fluctuations. They recognize these movements simply as the price you pay in order to earn higher rates of return over long periods of time. Of course, it is incredibly difficult to always avoid having a short term focus, but understanding this behavioral bias can help. Hindsight Bias: Believing that unpredictable past events, in retrospect, were obvious and predictable.In looking back at the credit crisis, technology bubble, and even the collapse of Enron, it now seems obvious that these events were certain to happen. However, it is easy to forget the circumstances surrounding these events at the time they occurred. As investors we need to recognize that it was impossible to have predicted these events (and future shocks will eventually happen). Instead, we should focus on the elements of our investment approach that we can control – such as the stock/bond mix, diversification and our response to portfolio fluctuations. Over Confidence: Rating oneself as above average when it comes to selecting investments.Fueled by the fact that the news channels need confident and dynamic personalities to keep viewers and advertisers, many of the pundits we see on TV tend to be very certain in their ability to predict the future direction of the markets. After all, who would continue to watch an indecisive pundit who always said “keep focused on the long term,” or “I don’t really know what’s going to happen?”Academic research has consistently shown that the investment performance of money managers rarely outperform the markets – this applies doubly to television personalities.Gambler’s Fallacy: Perceiving trends where none exist and taking actions on these faulty observations.This behavioral bias was particularly prevalent during the late 1990s as all technology and internet based stocks soared to spectacular heights irrespective of company earnings. An investor’s desire to invest in “last year’s winners” is also an indication of this bias. It is particularly important to recognize the cyclical nature of the economy and financial markets and avoid performance chasing.In order to avoid the mistake of behavioral biases in your investment strategy, we believe it can be helpful to ask yourself the following questions:
1. Have my long term investment objectives changed?
2. Are the changes I am considering based on an emotional or behavioral response to past, current, or expected future events?
3. Is it possible that I (or the pundits, etc.) am wrong about what will happen in the future? If so, what could be the long term impact of this decision as it relates to my investment goals?
In general, we subscribe to the mindset that the investment markets are very efficient and that stock and bond prices immediately and accurately reflect all available information. As such, we adhere to a long term investment approach that is grounded by making strategic financial planning decisions. We hope that you will too!