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Realizing Investor Biases

One of the biggest risks to investors’ wealth is their particular behavior. A lot of people, including investment professionals, are vulnerable to emotional and cognitive biases that result in less-than-ideal financial decisions. By identifying subconscious biases and understanding how they can hurt a portfolio’s return, investors can develop long-term financial plans to simply help lessen their impact. The following are some of the very common and detrimental investor biases.

Overconfidence

Overconfidence is one of the very prevalent emotional biases. Everyone, whether a teacher, a butcher, a mechanic, a doctor or a mutual fund manager, thinks he or she can beat industry by deciding on a few great stocks. They manage to get thier ideas from a variety of sources: brothers-in-law, customers, Internet forums, or at best (or worst) Jim Cramer or another guru in the financial entertainment industry.

Investors overestimate their particular abilities while underestimating risks. The jury continues to be from whether professional stock pickers can outperform index funds, nevertheless the casual investor is sure to be at a disadvantage contrary to the professionals. Financial analysts, who have usage of sophisticated research and data, spend their entire careers trying to ascertain the right value of certain stocks. Several well-trained analysts focus on only one sector, as an example, comparing the merits of investing in Chevron versus ExxonMobil. It’s impossible for a person to keep per day job and also to do the right due diligence to keep a portfolio of individual stocks. Overconfidence frequently leaves investors with their eggs in far not enough baskets, with those baskets dangerously close to 1 another.

Self-Attribution

Overconfidence is usually the result of the cognitive bias of self-attribution. This can be a kind of the “fundamental attribution error,” in which individuals overemphasize their personal contributions to success and underemphasize their personal responsibility for failure. If an investor happened to get both Pets.com and Apple in 1999, she might attribute the Pets.com loss to the market’s overall decline and the Apple gains to her stock-picking prowess.

Familiarity

Investments may also be often subject to an individual’s familiarity bias. This bias leads visitors to invest most of the money in areas they feel they know best, rather than in a properly diversified portfolio. A banker may produce a “diversified” portfolio of five large bank stocks; a Ford assembly line employee may invest predominantly in company stock; or a 401(k) investor may allocate his portfolio over a variety of funds that focus on the U.S. market. This bias frequently results in portfolios minus the diversification that will enhance the investor’s risk-adjusted rate of return.

Loss Aversion

Many people will irrationally hold losing investments for longer than is financially advisable as a result of the loss aversion bias. If an investor makes a speculative trade and it performs poorly, frequently he will continue to put on the investment even if new developments have made the company’s prospects yet more dismal. In Economics 101, students learn about “sunk costs” – costs which have been already incurred – and that they should typically ignore such costs in decisions about future actions. Only the long run potential risk and return of an investment matter. The inability to come calmly to terms having an investment gone awry can lead investors to get rid of more income while hoping to recoup their original losses.

This bias may also cause investors to miss the opportunity to capture tax benefits by selling investments with losses. Realized losses on capital investments can offset first capital gains, and then around $3,000 of ordinary income per year. By utilizing capital losses to offset ordinary income or future capital gains, investors can reduce their tax liabilities.

Anchoring

Aversion to selling investments at a loss may also result from an anchoring bias. Investors may become “anchored” to the first cost of an investment. If an investor paid $1 million for his home during the peak of the frothy market in early 2007, he may insist that what he paid may be the home’s true value, despite comparable homes currently selling for $700,000. This inability to adjust to the brand new reality may disrupt the investor’s life should he need to market the property, for example, to relocate for a better job.

Following The Herd

Another common investor bias is following the herd. Once the financial media and Main Street are bullish, many investors will happily put additional funds in stocks, regardless of how high prices soar. However, when stocks trend lower, many individuals won’t invest until industry indicates signs of recovery. Consequently, they cannot purchase stocks when they’re most heavily discounted.

Baron Rothschild, Bernard Baruch, John D. Rockefeller and, lately, Warren Buffett have all been credited with the word this one should “buy when there’s blood in the streets.” After the herd often leads people to come late to the party and buy at the top of the market.

For example, gold prices more than tripled previously three years, from around $569 an ounce to more than $1,800 an ounce at this summer’s peak levels, yet people still eagerly invested in gold as they been aware of others’ past success. Given that the majority of gold is used for investment or speculation rather than for industrial purposes, its price is highly arbitrary and subject to wild swings centered on investors’ changing sentiments.

Recency

Often, following the herd is also a results of the recency bias. The return that investors earn from mutual funds, called the investor return, is typically lower than the fund’s overall return. This isn’t because of fees, but instead the timing of when investors allocate money to specific funds. Funds typically experience greater inflows of new investment following periods of good performance. Based on a study by DALBAR Inc., the average investor’s returns lagged those of the S&P 500 index by 6.48 percent each year for the 20 years ahead of 2008. The tendency to chase performance can seriously harm an investor’s portfolio.

Addressing Investor Biases

The first faltering step to solving a problem is acknowledging that it exists. After identifying their biases, investors should seek to lessen their effect. Whether or not they’re dealing with financial advisers or managing their particular portfolios, the simplest way to do so is to produce a plan and stay glued to it. An investment policy statement puts forth a prudent philosophy for a given investor and describes the types of investments, investment management procedures and long-term goals that will define the portfolio.

The principal basis for developing a written long-term investment policy is to stop investors from making short-term, haphazard decisions about their portfolios during times of economic stress or euphoria, which may undermine their long-term plans.

The development of an investment policy follows the basic approach underlying all financial planning: assessing the investor’s financial condition, setting goals, creating a strategy to generally meet those goals, implementing the strategy, regularly reviewing the results and adjusting as circumstances dictate. Utilizing an investment policy encourages investors to become more disciplined and systematic, which improves the odds of achieving their financial goals.

Investment management procedures might include setting a long-term asset allocation and rebalancing the portfolio infrastructure indices when allocations deviate from their targets. This technique helps investors systematically sell assets which have performed relatively well and reinvest the proceeds in assets which have underperformed. Rebalancing might help maintain the right risk level in the portfolio and improve long-term returns.

Selecting the right asset allocation may also help investors weather turbulent markets. While a portfolio with 100 percent stocks might be appropriate for one investor, another might be uncomfortable with even a 50 percent allocation to stocks. Palisades Hudson recommends that, all the time, investors reserve any assets that they will need to withdraw from their portfolios within five years in short-term, highly liquid investments, such as for instance short-term bond funds or money market funds. The right asset allocation in combination with this short-term reserve should provide investors with an increase of confidence to stick for their long-term plans.

While not essential, a financial adviser will add a coating of protection by ensuring that an investor adheres to his policy and selects the right asset allocation. An adviser can offer moral support and coaching, that’ll also improve an investor’s confidence in her long-term plan.

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