Much has been written about common investor mistakes and the conclusion seems to be that we are our own worst enemies. In fact, there is even a term called the “Investor Behavior Penalty.” This refers to the phenomenon of the average stock fund investor’s returns consistently trailing way behind the average stock fund return during the same time period. The chart below gives a clear and sobering visual:

 

graph for BF

Whatever the size of your portfolio, missing out on the average annual return really adds up. You might be thinking “it’s a good thing I’m not the average investor!” but that mentality is exactly what can lead to the investor behavior penalty (see #2 in the list below). Below is a pared down explanation of investors’ 10 most common behavioral biases from RPSeawright.com (click the link for the full article):

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1. Confirmation Bias. We like to think that we carefully gather and evaluate facts and data before coming to a conclusion. But we don’t. Instead, we tend to suffer from confirmation bias and thus reach a conclusion first.

2. Optimism Bias. This is a well-established bias in which someone’s subjective confidence in their judgments is reliably greater than their objective accuracy. We are only correct about 80% of the time when we are “99% sure.” Since 80% of drivers say that their driving skills are above average, I guess none of them drive on the freeway when I do. In a finding that pretty well sums things up, 85-90% of people think that the future will be more pleasant and less painful for them than for the average person.

3. Loss Aversion. We are highly loss averse. Empirical estimates find that losses are felt between two and two-and-a-half times as strongly as gains. Thus the disutility of losing $100 is at least twice the utility of gaining $100. Loss aversion favors inaction over action and the status quo over any alternatives.

4. Self-Serving Bias. Our self-serving bias is related to confirmation bias and optimism bias. Self-serving bias pushes us to see the world such that the good stuff that happens is my doing (“we had a great week of practice, worked hard and executed on Sunday”) while the bad stuff is always someone else’s fault (“It just wasn’t our night” or “we simply couldn’t catch a break” or “we would have won if the refereeing hadn’t been so awful”).

5. The Planning Fallacy. In his terrific book, Thinking, Fast and Slow, Nobel laureate Dan Kahneman outlines what he calls the “planning fallacy.” The planning fallacy is our tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits thereof.

6. Choice Paralysis. Intuitively, the more choices we have the better. However, the sad truth is that too many choices can lead to decision paralysis due to information overload. For example, participation in 401(k) plans among employees decreases as the number of investable funds offered increases.

7. Herding. We all run in herds — large or small, bullish or bearish. Institutions herd even more than individuals in that investments chosen by one institution predict the investment choices of other institutions by a remarkable degree.

8. We Prefer Stories to Analysis. We inherently prefer narrative to data — often to the detriment of our understanding. Keeping one’s analysis and interpretation of the data reasonably objective – since analysis and interpretation are required for data to be actionable – is really, really hard even in the best of circumstances.

9. Recency Bias. We are all prone to recency bias, meaning that we tend to extrapolate recent events into the future indefinitely.

10. The Bias Blind-Spot. Unfortunately, we all tend to share a “bias blind spot” — the inability to recognize that we suffer from the same cognitive distortions that plague other people.

Being aware of the mistakes investors make and why they make them is fascinating, but I think it’s important to address overcoming the behaviors that may lead to these unwise decisions. Reading the list above might make you think you can’t trust your own judgment, and maybe that’s the takeaway. After all, it’s really hard for people to make objective decisions, and maybe even harder to recognize that even you (that means me too) are one of those people.

This is where community and counsel can factor in to your decision making. Perhaps the remedy for these biases is to invite objective people to help you evaluate the decisions that impact your future: a trusted financial advisor to talk you out of selling low and buying high, a mentor in your profession to run your start up plan before you quit your corporate job, or conversations with locals before you buy the bigger house in the next town over.

Ed Blog Photo 2

Ed Meek, CFP®