Friday, 5 October 2012

Cognitive Biases That Cause Bad Investment Decisions

Henry Stimpson
Published: Tuesday, November 29th 2011

When it comes to investing, you might think your emotions don’t play a role, but they do without you even realizing it. Everyone has emotional and cognitive biases that shape their choices, and only by spotting them can you overcome them so they don’t cause bad investment decisions, according to Ben Sullivan, a certified financial planner at Palisades Hudson Financial Group.
Sullivan recalls a number of clients who have made mistakes in the past. A middle-aged banker had more than half of his $500,000 portfolio in a few bank stocks. Another prospective client sold his business to a big consumer-goods company had almost all his money — many millions — in that company’s stock. An employee believed his 401(k) plan was diversified because he owned four funds — all large-cap stock funds.
“Investor mistakes have predictable patterns,” says Sullivan. “Our pervasive emotional and cognitive biases often lead to poor decisions.”

It’s easy to overestimate your own abilities in picking stocks while underestimating risks. Even professional money managers struggle to beat index funds. The casual investor has little chance, Sullivan says.
“It’s almost impossible to have a day job and moonlight as manager of your individual-stocks portfolio,” he says. “Overconfidence frequently leaves investors with their eggs in far too few baskets, with those baskets dangerously close to one another.”

his is a cognitive error leading to overconfidence. Someone who bought both and Apple in 1999 might dismiss his loss (it went bankrupt) because the market tanked but believe he’s an investment whiz because he bought Apple.

Investing in what you “know best” can be a siren song leading investors astray from a prudently diversified portfolio. That was the case with all three investors mentioned above. They were familiar with banks, consumer goods and large-cap U.S. stocks respectively, Sullivan says, and unwisely put all their eggs in that familiar basket.

Anchoring and loss aversion

Investors may become “anchored” to the original purchase price. Someone who paid $1 million for his home in 2007 may insist that what he paid is the home’s true value, even though it’s really worth $700,000 now. The same holds for securities.
“Only the future potential risk and return of an investment matter,” Sullivan says.
Inability to sell a bad investment and take a loss causes investors to lose more money as the hoped-for recovery never happens.
“You’ll also miss the opportunity to capture tax benefits by selling and taking a capital loss,” he adds.

Herd fever
When the market is hot and high, the media and everyone else say buy. When prices are low — remember March 2009 — everyone says sell. Following the herd leads investors to come late to the party so that they’re buying at the top and selling at the bottom. Following the herd is a powerful emotion.
Today, Sullivan says, the herd is buying gold and U.S. Treasuries.

According to a study by DALBAR Inc., the average investor’s returns lagged those of the S&P 500 index by 6.5% per year for the 20 years prior to 2008 largely because of recency bias. People invested in last year’s hot funds, which often turn sour next year, instead of taking a steady course, he says.
(Ed: Read about how the recency effect has been influencing the housing market.)

Counteracting your biases

Having a written plan is the key, Sullivan says.
“Create a plan and stick to it,” he says.
Hewing to a written long-term investment policy prevents you from making haphazard decisions about your portfolios during times of economic stress or euphoria. Selecting the appropriate asset allocation will help you weather turbulent markets.
All investors should invest assets they will need to withdraw from their portfolios within five years in short-term liquid investments. Combining an appropriate asset with a short-term reserve gives investors more confidence to stick to their long-term plans, he says.
If you can’t control your emotions — or don’t have the time or skill to manage your investments — consider hiring a fee-only financial adviser, Sullivan says. An adviser can provide moral support and coaching, which will boost your confidence in your long-term plan and also prevent you from making a bad, emotionally driven decision.
“We all bring our natural biases into the investment process,” Sullivan says. “Though we cannot eliminate these biases, we can recognize them and respond in ways that help us avoid destructive and self-defeating behavior.”

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