This article first appeared on Nasdaq.
People don’t make rational decisions, including decisions about investing. The degree to which we make ludicrous choices depends on our DNA. (No, really; bear with me.) Decision making by both investors and advisors can be less reckless if we don’t understand more about individual behaviors and why we make the financial decisions we do. Are we hardwired to derail our own investments?
Factor into this mix emotion and a lack of financial education, and this further increases the likelihood that decision making can be faulty for both advisors and investors. Getting inside our brains to see what’s going on when we make decisions is not only doable, it’s also measurable.
As behavioral finance (think How and why we make the financial decisions we do) goes mainstream, investor behavior has become more accepted as the major influence on investment performance. If advisors have no read on how or why investors make certain decisions, mistakes will be made.
So how does one become what I would call Behaviorally Smart? According to its annual Quantitative Analysis of Investor Behavior, Dalbar – a financial services market research firm – says investment losses to individual investors due to their behavior is an average of 8 percent per year over the last 30 years.
And this is not just limited to the investor. Based on a study by Cabot Research, professional investment managers are leaving 1 percent to 3 percent a year on the table, which is significant when you realize the size of these large portfolios. So even the professionals who use sophisticated technology and extensive research make mental errors in decision making.
After all, they are human and must manage cognitive biases and emotions when under pressure. The more aware you are of yourself and what makes you successful and what causes failure, the better off you’re going to be financially and professionally.
So, how can investors improve? There is no simple tonic to improved performance, as this requires wholesale behavioral change – a paradigm shift in how someone engages the world around them. The key, then, is understanding your unique financial personality. Among other things, this insight provides a greater level of self-awareness: Why do we repeat our mistakes?
Advisors and investors alike need to develop an investment process that provides a check yourself before you wreck yourself step to mitigate these blind spots.
Through more than 15 years of research, I have learned that easily identifiable behavioral traits lead to patterns of decision making that are very closely aligned with the structure of an investors portfolio. In other words, the combination of traits and patterns makes up your financial personality style. Your portfolio, therefore, mirrors who you are. In fact, investors should look at their portfolio as the composition of all their decisions and not just a series of market positions.
The reality is that some behavioral biases cost more than others. Based on Cabot Research, the top four ways the brain can wreck investment performance are:
- The Endowment Effect – Holding winners too long. The investor falls in love with a winner and loses sight of the fact that its best days are gone. There is the fear of selling the position too early.
- Risk Aversion – Selling young winners too early. The investor has fears about the future and does not want to take the bumps in the road as the stock increases in value.
- Loss Aversion – Holding losers for too long. The investor is fearful of taking a loss and ends up with a portfolio full of losers.
- Regret Aversion – Not adding to winners when they take off. This is an investor who is hesitant in their decision-making and backs out of building the stock position as it gains momentum.
Based on your history of decision-making, which of these patterns have cost you the most? And remember, there are many other behavioral biases, which, coupled with these, will further contribute to reduced performance. To help you on the journey of closing the investment performance gap, start with self-awareness of your behavioral traits.
For investors, this could be as simple as asking your advisor if he or she uses a validated behavioral insights tool that looks beyond risk-tolerance testing. For advisors, the time and money invested in adopting such a process can pay big dividends for you and your client, pun intended.
Why not complete your own complimentary profile and see which behavioral biases may affect your financial decision-making? Click here