The behavioural traps investors need to avoid
Darren Cunneen outlines six key behavioural traps to be aware of when investing, and some tips for helping clients to sidestep them.
Investing is fraught with many challenges. Perhaps the most overlooked are behavioural biases – allowing emotions or fallible human traits to influence investment decisions. Heightened market noise can also drown out rational thought, leading to clouded decision-making.
Even the savviest investor can be susceptible.
1. Loss aversion
Rational people typically avoid undue risk, meaning they are risk-averse. Consequently, they require sufficient reward to compensate for taking on additional risk.
This is the underlying principle of traditional finance theory, but despite this common logic, investors can inadvertently become risk-seeking.
Holding on to a struggling fund with the aim of recouping losses, or at the very least breaking even, can lead to such a bias, resulting in investors taking on risk with little expected reward.
Known as ‘loss aversion’, this stems from an unwillingness to recognise or accept losses.
Growth and prosperity mute the presence of this bias due to fewer losses – a scenario experienced by complacent investors before the Global Financial Crisis.
However, market conditions for growth assets have turned south, and many investors have been hurt.
Addressing loss aversion in today’s downtrodden market conditions has become part and parcel of investing.
As no fund manager gets all their calls right, we don’t suggest selling funds on the basis of poor performance alone, especially over the short term.
However, investors and advisers should revisit a fund’s fundamentals to make sure that there have been no changes – for example, to the team or process.
Importantly, if there has been a major catalyst for the underperformance that affects the fund’s chances of recouping losses – such as the departure of a key person – it may be time to look elsewhere.
2. Anchoring bias
Investors can also fixate on a particular datapoint or target number – a sticky figure they believe will be attained in the future, irrespective of any refuting evidence.
Known as ‘anchoring’, this trait can be applied to all investments, the figure in mind underpinning current and future investment decisions.
For example, the S&P/ASX200 Index hit an all-time high of just over 6800 in November 2007, while at the time of writing the index was trading around 4440.
Investors who are focused on and ‘anchored’ to this previous high anticipate that the index will revert in due course, and may consequently overexpose themselves to Australian equities.
To avoid anchoring, we recommend assessing investments objectively, giving new information the weight it deserves, and updating targets accordingly.
3. Home bias
Individuals are naturally more comfortable in familiar territory, with investing no exception.
Particularly in developed economies, investors place a disproportionate amount of their wealth in domestic assets over foreign counterparts, leading to a behavioural trait known as ‘home bias’.
This overdependence on home country assets leads to an inherent riskiness and lack of diversification. Investors may not only be sacrificing the risk reduction benefits of global and emerging market securities, but also the potential for increased returns.
Australians have historically been prone to home bias, the average portfolio skewed significantly towards domestic assets.
While this has been successful for many investors – Australian shares having largely outperformed international shares over the past decade – having too many eggs in one basket produces a portfolio exposed to similar risks.
Should one of these risks materialise, the result could be disastrous.
To overcome ‘home bias’, we recommend establishing appropriate global allocations within a strategic asset allocation framework, and implementing accordingly.
For investors fearing the unknown global market, a passively-managed international fund might be an easy solution, removing the need to make active management decisions about fund managers, investment styles, and so forth.
4. Overconfidence bias
Confidence in your fund is a positive, but overconfidence, if left unchecked, can lead to an under-estimation of the risk involved and an over-estimation of the upside.
The effects of ‘overconfidence bias’ can be twofold.
First, such hubris means that investors can be overly assured of their abilities to identify best-of-breed funds.
A common remedy for this is to seek out an opposing view or second opinion.
Research can provide this and serve as a sense-check on the level of conviction held in a particular fund, and its long-term potential.
Secondly, overconfidence can cause an overreliance on certain funds.
For example, an individual may invest heavily in a risky high-conviction or geared strategy with the expectation of a high return, resulting in a poorly-constructed portfolio.
Investors and advisers can mitigate this by paying close attention to the role an investment strategy is intended to play in an investment portfolio, and monitor this periodically.
5. Status quo bias
‘Status quo bias’ is a tendency for investors to take an inactive approach to investing, a ‘do-nothing’ strategy.
A number of factors, including loss aversion, can put the brakes on active management of personal investments.
By maintaining the status quo, however, investors allow asset allocations to stray without intervention, leading to sub-optimal asset allocations.
Consequently, the risk characteristics of a portfolio can change markedly. Investors may also forgo potentially profitable or diversifiable fund opportunities.
6. Herding
People tend by nature to avoid the mental anguish of going against the crowd, on the basis of the rationale that the consensus is unlikely to be wrong. (They also value the comfort of solidarity.)
This can lead to a behaviour known as ‘herding’, whereby investors think and invest harmoniously.
This has been observed on multiple occasions throughout history, most recently in the ‘dotcom bubble’ in the late 1990s and arguably more recently in the initial public offering of Facebook FB.
The recent exodus out of risky assets and flight-to-safety is arguably another example of herding, with some investors willing to accept negative real yields from so-called ‘safe haven’ assets over acts of contrarianism.
Investing in funds is no exception. Choosing funds purely on the basis of their large size, trendiness, or popularity is a bad move.
Determining a fund’s investment merit, suitability, and total portfolio fit should take precedence.
If left unchecked, behavioural biases such as those we’ve discussed above will cloud judgement. Knowledge of these should help to avoid irrational decisions, avert some of the pitfalls of behavioural investing, and ultimately enhance returns.
This will keep investors on the right track to achieving their long-term goals.
Darren Cunneen is a fund research analyst at Morningstar.
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