We apparently get a quarterly newsletter from Charles Schwab called On Investing. It’s addressed to my wife, so I think we’re receiving it as a part of her brokerage account. I’ve read all of the ones that we have received so far, but I tend to do so with a bit of skepticism. After all, it is a publication written by brokerage company. It’s like when I read a scientific article or study that is funded by a pharmaceutical company. You have to read those more carefully and with a more critical eye. That being said, the newsletter does have some informative articles. An article titled “What is Your Biggest Investing Challenge?” was rather interesting. In it, they talked about certain “emotional biases” or behaviors that can contribute to investors making decisions that “aren’t always rational.” They also talked about the importance of becoming familiar with these behaviors so that we can potentially identify them in ourselves. Below are the five behaviors they wrote about followed by some of my thoughts on them.
Loss Aversion – This investor will go to great lengths to avoid losses and may miss out on gains.
I can understand this behavior. I mean, nobody wants to lose money. I think of this type of investor as someone who would prefer the safe, guaranteed returns on things like a savings account or a CD at a bank. They’re guaranteed not to lose money (unless you account for inflation) and their holdings are FDIC insured. But that safety of avoiding losses comes at the expense of potential higher gains. Another example I can think of is the investor who may have shifted some money from stocks to bonds/cash earlier in the year, say in January, thinking the market was overvalued and that it would contract. Maybe they ended up staying out of the market this whole year on the assumption that the market would eventually correct itself. If so, they missed out on the 7.2% YTD gain seen by the S&P 500 index (as of Dec. 1).
Overconfidence – Often overestimating his expertise, this investor has a tendency to buy risky investments and hold an over-concentrated portfolio.
I think that this can be a big issue among investors, especially DIY investors. Heck, I think it’s an issue for everyone. We all think we’re above average when it comes to certain traits. I mean, we all think we’re above average drivers, or above average athletes, or above average in intelligence. This bias in ourselves, called illusory superiority, is one in which we overestimate our own abilities in relation to others. I’m sure we’ve all thought that we would be better at picking stocks or investments than the other investor. I think there is also a tendency for investors to overestimate their risk tolerance. It’s one thing to say that you have a high risk tolerance and be 100% in equities when things are going well. It’s another to see that same portfolio lose 30-40% of its value.
Status Quo – This investor is easily overwhelmed and is wary of making any changes to his portfolio even if it’s in his best interest.
I’m not really sure what this one means. I would think that if you’re easily overwhelmed you might make impulsive changes. Maybe these are the investors who are afraid to adjust their portfolios as their circumstances changes, like nearing retirement age. I don’t know. Maybe you guys can help me out on this one.
Regret Aversion – As a result of past investments that turned out poorly, this investor makes conservative choices.
It makes sense that someone who lost a lot of money would want to avoid repeating that in the future by seeking more conservative investments. I think I would include this one under “loss aversion” rather than as a separate category. People make conservative choices both to avoid losses and to prevent it from happening again.
Representativeness – This investor tries to generate higher returns by chasing “hot” stocks or star fund managers.
I think a good example of this is the recent run-up in the financial sector. For instance, the Vanguard Financials ETF went up over 14% in November alone. For the year the ETF was up a little over 5% heading into November. What happened in November that could have pushed financial stocks higher? Hint: Trump victory. Maybe the prevailing thought is that his future policies, whatever they may be, will be beneficial for banks. Who knows, but I’m sure there are some investors out there right now who think that bank stocks are “hot” and are wanting to get in on some of the action. I also think this category is similar to something known in behavioral finance as herding. Essentially people want to invest in things that a lot of other people are investing in. One example of this herd mentality would be the dotcom bubble in 1999 where everyone was snatching up internet and tech stocks. If you didn’t know, there was also a bubble in tulips way back in 1634.
Overall, I thought the article was a good read. As investors, I think it is important that we’re cognizant of these potential behaviors or biases in ourselves. That way we can take actions to address them and hopefully not make too many costly mistakes. Thoughts? Opinions? Concerns? Comment below.