Despite unprecedented and ever-increasing access to economic and investment data, study after study has shown that the track record of private investors is not encouraging. Moreover, they typically do not realize they underperform the market. In fact, over the 20-year period ending in 2018, the average equity fund investor achieved a 3.88% annualized return, whereas the average S&P 500 Index returned 5.62%. Fixed-income investors fared even worse, realizing an average return of 0.22% compared to 4.55%by Barclays Aggregate Bond Index.
As the chart below shows, a $100,000 equity investment made 20 years ago and managed by an average equity investor would have been worth nearly $85,000 less at the end of last year than an S&P 500 index-tracking fund. That same investment, managed by an average fixed-income investor, would have been worth little less than half of what an investment in a Barclays Aggregate Bond Index-tracking fund would have been after 20 years.
The overriding reasons behind investors’ underperformance are behavioral biases that cause them to act on emotion and deep-seated misperceptions about investment risk.
Behavioral biases relate to how we process information to reach decisions and our preferences. They can affect all types of decision-making but have particular implications about money and investing.
These biases tend to sit deep within our psyche and may serve us well in certain circumstances. However, investing often leads us to move into market tops and bail out at market lows. These biases, combined with common misunderstandings about investment risk, can be thought of as five categories of destructive investment tendencies that private investors face, as shown in the graphic below.
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At Wintrust Wealth Management, we see evidence of these tendencies in our clients’ thinking all the time. A desire to remove asset classes perceived to be risky or unfamiliar (real estate, international equities, etc.) from their portfolios that, in fact, actually increases volatility. A preference for a particular asset class or investment vehicle based on the most recent year’s performance. A request to wait on putting cash to work until the (presumed) impending market correction comes. They are deep-seated in many and adversely affect the ability to realize long-term financial goals.
To reduce the influence of these destructive tendencies, investors must first understand what they are and how they influence their thinking.
Overconfidence
Psychological studies have shown that we all tend to have unwarranted confidence in our decision-making. This trait appears universal, affecting most aspects of our lives. Researchers have asked people to rate their own abilities, for example, in driving, relative to others and found that most people rate themselves in the top third of the population. Few people rate their abilities as below average, although by definition, 50% of all drivers are below average. Many studies—of company CEOs, doctors, lawyers, students, and doctors’ patients—have also found that these individuals tend to overrate the accuracy of their views of the future.
Overconfidence is linked to the issue of control, with overconfident investors believing they exercise more control over their investments than they do. In one study, affluent investors reported that their stock-picking skills were critical to portfolio performance. In reality, they were unduly optimistic about the performance of the shares they chose and underestimated the effect of the overall market on their portfolio’s performance. In this simple way, investors overestimate their abilities and overlook broader factors influencing their investments.
Overconfidence has direct implications for investing, which can be complex and involve forecasts of the future. This is evident when investors overestimate their ability to identify winning investments. Traditional financial theory suggests holding diversified portfolios so that risk is not concentrated in any particular area. A misguided conviction can weigh against this advice, with investors or their advisers “sure” of the promising prospects of a given investment, causing them to believe that diversification is, therefore, unnecessary.
Overconfidence also tends to produce stubborn investing. This can be seen in “conservatism bias,” which describes the idea of the decision maker clinging to an initial judgment despite new, contradictory information.
A third way overconfidence adversely affects investing decisions is the tendency to trade too frequently, often with a negative effect on returns. A study of U.S. investors with retail brokerage accounts found that more active traders earned the lowest returns. The table to the right shows the results for the most and least active traders. For the average investor switching from one stock to another, the stock bought underperformed the stock sold by approximately 3.0% over the following year. Whatever insight the traders think they have, they appear to overestimate its value in investment decisions.
Underlying this overconfidence is a number of attitudes investors tend to hold that they should be mindful of. Foremost is a characteristic known as ‘self-attribution bias.’ In essence, this means that individuals faced with a positive outcome following a decision will view that outcome as a reflection of their ability and skill. However, when faced with a negative outcome, this is attributed to bad luck or misfortune. This bias gets in the way of the feedback process as decision-makers block out negative feedback and miss the opportunity to improve future decisions.
Similarly, hindsight bias fuels overconfidence. The statement “I knew the whole time this would happen” shows that we have an explanation for everything after the fact. This hindsight bias keeps us from learning from our mistakes. Even if prices rise, we keep buying. “What the heck, I’ll buy it again because it’s cheaper than last time,” we say. In other words, the typical private investor buys high and sells low—wasting a lot of money in the long term.
Additionally, confirmation bias, which is the phenomenon of supporting our own opinions with selective information, fuels overconfidence. Investors seek confirmation for their assumptions. They avoid critical opinions and reports, reading only those articles that put their decision in a positive light. This is also common in the media. Business journalists will report on innovative, creative companies that are all making a profit in bull markets. However, they rarely point out that not all companies using those same criteria succeed, as it would undermine the reporting narrative. We cannot avoid reading the headlines about price gains and booming markets or the multitude of success stories, and, unfortunately, these stories attract the interest of many amateur investors.
Inertia
Inertia is the failure to act. A related issue is a tendency for emotions to sway investors from a course of action they have committed to (i.e., having second thoughts). The desire to avoid regret is one driver of these behaviors. Inertia can act as a barrier to effective financial planning, stopping investors from saving and making necessary changes to their portfolios. A fundamental uncertainty or confusion about how to proceed lies at the heart of inertia. For example, if an investor is considering changing their portfolio but lacks certainty about the merits of taking action, they may choose the most convenient path—wait and see. In this pattern of behavior, so common in many aspects of our daily lives, the tendency to procrastinate dominates financial decisions.
Another driver of inertia is the so-called “disposition effect” associated with our natural aversion to loss. Behavioral finance suggests investors are more sensitive to loss than to risk and return. Some estimates suggest that people weigh losses more than twice as heavily as potential gains. For example, most people require an even (50/50) chance of an increase of $5,000 in a gamble to offset an even chance of a loss of $2,000 before they find it attractive. The idea of loss aversion also includes the finding that people try to avoid locking in a loss. Consider an investment bought for $10,000, which rises quickly to $15,000. Investors are often tempted to sell to lock in the profit.
In contrast, if the investment drops to $5,000, investors tend to hold it to avoid locking in the loss. The idea of a loss is so painful that investors tend to delay recognizing it. More generally, investors with losing positions show a strong desire to get back to break even. This means investors show highly risk-averse behavior when facing a profit (selling and locking in the sure gain) and more risk-tolerant or risk-seeking behavior when facing a loss (continuing to hold the investment and hoping its price rises again).
Research done to test this idea using data from a U.S. retail brokerage found that investors were roughly 50% more likely to sell a winning position than a losing position, even though tax regulations make it beneficial to defer locking in gains for as long as possible while crystallizing tax losses as early as possible. It also found that the tendency to sell winners and hold losers significantly harmed investment returns.
Naïve Diversification
Behavioral finance research suggests that investors sometimes struggle to apply the concept of portfolio diversification in practice. Evidence suggests that investors use “naïve” rules of thumb for portfolio construction in the absence of better information. One such rule has been dubbed the 1/n approach, where investors allocate equally to the range of available asset classes or funds (“n” stands for the number of options available). This approach ignores the specific risk-return characteristics of the investments and the relationships between them.
Another common example of naïve diversification is the tendency for some investors to hold extreme portfolio allocations. On the one hand are aggressive investors who only hold all-equity portfolios. On the other hand are ultra-conservative investors who are reluctant to hold anything other than bonds. Many such investors need the help of an investment professional to ensure a balance of risk and return in portfolios.
Naïve diversification also occurs when investors apply their well-documented preference to invest in familiar assets, which they often mistakenly associate familiarity with low risk. This “home bias” manifests itself in high portfolio weights in assets from an investor’s own country. They are more familiar with and confident about local investment opportunities, so even though it is much easier than in the past to diversify investments across geographies, investors tend to go with what they know and can easily understand. In so doing, they miss out on important diversification opportunities that can not only lower risk but improve returns. For more on home bias and how to avoid it, see our paper, An International Investing Primer, from April 2015.
Home bias also is apparent in the tendency of investors to buy shares in the companies they work for. In doing so, investors may become over-allocated to their company’s stock and the unsystematic risks that come from being under-diversified. Individuals over-allocated to company stock risk having their assets and their income significantly reduced should the company go through a period of financial difficulty.
See our Summer 2023 issue for the second part of this article.
Nina Azwoir, First Vice President of Investments, Wintrust Wealth Management. © Morningstar 2020. All Rights Reserved. Used with permission. This information may answer some questions but is not intended to be a comprehensive analysis of the topic. In addition, such information should not be relied upon as the only source of information, competent tax and legal advice should always be obtained.
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