It’s not controversial to say that investing biases can hurt the performance of your portfolio. Most investors would agree. And yet by its very nature a bias—an unreasoned opinion—will often be invisible to the person holding it.
You can find evidence of this in a recent DALBAR, Inc. study of investor behavior. Researchers found that over the 20-year period ending December 31, 2020, individual stock fund investors consistently underperformed a market benchmark index. During the studied period the S&P 500 had an average annualized return of 7.43%. The Global Equity Index 100 averaged 8.29%. And yet the portfolios of individual investors averaged only 5.96%, a sizeable underperformance. (That number would be even lower if you took out the individuals who passively tracked with the indexes.)
So what does this have to do with investing bias?
Over that 20-year period many investors pursued strategies they thought would enable them to beat the market. But they didn’t. So in this case their unreasoned assumptions—their biases— caused them to act against their own self-interest.
Kiplinger’s recently listed the seven investing behaviors that can torpedo your portfolio. And while all of them can be restated as biases, all of them are not equal in their power to fool you into making poor decisions.
The first three—Fear of Missing Out (FOMO), Overconfidence, and Confirmation Bias (seeking only information in favor of your action)—are relatively easy to spot. And an experienced investor might call them beginner’s mistakes.
But the next four they list are tougher to avoid because they each strike a chord in our human nature.
Loss Aversion. It’s a simple fact that the emotional sting of losing something outweighs the good feelings associated with gaining that same thing. In investing, this bias for the avoidance of pain at any cost can lead to a skewed approach to risk. But retreating into a “sure thing” can often lead to further losses.
Lack of Patience. This is often called the action bias. When something dramatic is happening, an inner voice urges, “Don’t just stand there. Do something!” This can be good when helping someone who’s been injured, or tossing a life ring to someone drowning. But if it prompts you to react to short-term market volatility, it can lead to long-term losses.
Gambler’s Fallacy. It’s the belief that a random event is due to happen. If you flip a coin nine times and all nine times it comes up heads, then common sense says there’s an overwhelming chance that on the tenth toss it will come up tails. But the chances of getting heads are the same for every toss, 50/50. This bias causes investors to believe they can predict when the market is fated to move in some way.
Recency Bias. Simply put, the last thing you hear figures more prominently in your mind. (This is why you want to go second in a debate.) Unfortunately, this bias causes you to assign less validity to things you know to be true but simply haven’t heard about in a while. It’s one of the factors that fuels investing fads. And it’s a good reason to periodically review the basics of prudent investing.
As humans we’ll always be subject to unreasoned assumptions. But as an investor you can greatly diminish their influence by following the long-term plan we’ve developed to help keep you on track when emotions are prompting you to make poor choices.
