As much as we may hate to admit it, we’re only human. That means we’re quite different from the “rational man”, Homo Economicus, that all the Economics textbooks were written for and about. While that guy is perfectly rational, considers all the relevant information, and optimizes his utility, we humans don’t. We can only handle so many facts before we’re overwhelmed, we tend to approach decisions emotionally, and we see patterns where none exist.
In a previous HCM blog, we covered a few biases and how they affect investment returns. In this blog, we’ll be covering how Overconfidence, Familiarity, and the Gambler’s Fallacy can affect your decision making, as well as what to do to account for these biases.
Overconfidence bias is the tendency to be overly optimistic about the quality of your information and/or your ability to act on it at the right time for maximum gain. This shows up everywhere in life: one study found that up to 80% of drivers believe they are safer than the average driver. Other studies of professionals, such as doctors, lawyers, and CEOs, found them to have unrealistically high estimations of their abilities. While confidence is a good thing, overconfidence can get you into trouble.
One way we see overconfidence inflicting negative outcomes on investors is through excessive trading. One study by Barber and Odean found that investors utilizing advisors traded less and achieved better results than investors trading more actively and speculatively online. In another of their studies, they found a negative correlation between trading activity and portfolio returns, with the 20% most active traders earning 7.1% less than the 20% least active traders. Upon further investigation, they found that investor confidence was a prime factor inspiring the active investors to trade so frequently.
So how do you avoid this bias and realize better returns? Trade less and invest more. Anymore, you’re trading against institutional investors with resources you don’t have and algorithmic robots that trade at frequencies you simply can’t match. One study on this topic found more frequent retail traders are “basically paying fees to lose money”. Pay attention to the long-term secular trends, buy companies with good fundamentals, take advantage of dividend-paying stocks, and you’ll build wealth and income over time.
Many of us are creatures of habit. We take the same route to work, we go to the same stores for the same things, we eat at the same restaurants, etc. Why? Because humans are comfortable with familiar things. Familiarity bias, in investing, is the preference of individuals to remain confined to what is familiar to them. This takes a lot of forms, from only investing in stocks from your home country, to over-investing in your employer’s stock, to choosing stocks whose products you frequently use and enjoy.
Why is this an issue? Well, for starters, it leads to chronic under-diversification. A report published by the Securities and Exchange Commission (SEC) found that, while an investor should hold approximately 300 securities to be properly diversified, the average investor holds four. A 2008 study found that portfolios above $25,000 held seven stocks on average, and portfolios above $100,000 held an average of 12 stocks. Of course, proper use of ETFs is another good way to achieve proper diversification.
Why is under-diversification a problem? The less diversification you have in your portfolio, the more susceptible you are to market volatility exerting undue influence on your savings. Investing in your home country leaves you open to swings that could be counterbalanced by investing in international markets. From 1991 to 2013, almost half of the time international stocks outperformed US stocks, sometimes by as much as 22%. Overinvesting in your own company can leave you doubly exposed: for one, you’re already “invested” in your company by virtue of working there and drawing a salary from it. If an economic downturn were to occur, you may lose compensation or be furloughed, and you’d see a decrease in your retirement assets as well, giving you a double dose of financial pain. Choosing only stocks whose products you’re familiar with opens you up to a similar problem. The S&P 500 is grouped into 11 sectors; it’s highly unlikely that you come into direct contact with each of these sectors on a regular basis.
One way to address familiarity bias is to alter your perspective. Say to yourself, “if I just won $1,000,000 in the lottery, would I only invest in what I already know?” The answer is probably not. Another way to address this is to talk through your investments. Having a sounding board, such as a financial advisor, to work through investment choices can be an excellent way to avoid getting caught in this financial trap.
The Gambler’s Fallacy
Let’s say you’re sitting at the slot machine in Vegas. You’ve been playing for hours, and you haven’t heard any bells ring. You need to keep playing, right? Aren’t you due for a big payout?
Well… no. This is an example of the Gambler’s Fallacy, the belief that future probabilities are altered by past events. This is a product of “representativeness” and leads us to overly rely on rules of thumb, or “stereotypical thinking”.
How does this impact investing? Let’s say, instead of a slot machine, you’re watching the S&P. It has a week of big positive returns, so you place a short-sale trade (betting the market will fall). It’s due, right? What goes up must come down, trees don’t grow to the sky. Well, no. A run of good returns doesn’t necessarily foretell a bad return.
How does this affect investors? We’ve been in a bull market for over a decade now. A lot of investors are starting to get nervous, feeling like we’re due for a downturn. As such, they may prematurely bow out of the market before the signs and data say that they should.
How can you address the Gambler’s fallacy? Take a disciplined, data-driven approach to investing. Simply knowing about the fallacy can help you avoid falling for it. Learn to see each event as a new beginning rather than a continuation of what previously transpired. Ask your advisor about this for more information.
To put it simply, people are complicated. They can only process so much information, and they often bring emotion into logical decision. This can result in approaching investments too confidently, only investing in what they already know, or believing an event is “due” for a payday. The first step to beating these biases is understanding them. After that, talk to a financial advisor about how to make sure your assets are invested to help you achieve your financial independence and retirement goals.