Behavioral biases are common obstacles to investment success. Even the most rational individuals are vulnerable to making poor investment decisions based on erroneous conclusion or emotional reaction to new information. Behavioral biases contribute to the often-documented tendency of investors to achieve inferior returns relative to market benchmarks.
Investors who have a strategy for avoiding behavioral biases are more likely to earn investment success.
Manage emotions. Studies show that investors feel greater pain from investment losses than satisfaction from investment gains. Investors who were hurt by the bursting of the technology bubble in 2000 and the global financial crisis in 2008 have a justifiably heightened fear of investment losses. Emotions contributed to pain selling at several pivotal moments in 2016, notably in January in connection with concerns about China, as well as in the early hours following the Brexit vote in June and the election of President Donald Trump in November. Investors who calmly assessed the investment implications were more likely to benefit from the opportunities provided by each event.
Seek contrary opinions. Confirmation bias is the tendency to seek opinions validating an individual's point of view. The 2016 U.S. presidential election campaign was notable for the extent to which confirmation bias was central to the election narrative. Many voters received their news from sources thought to favor one political party over another, with Trump voters tending to get news from Fox (and Breitbart) and Hillary Clinton voters from CNN and the New York Times. Investors are vulnerable to confirmation bias, as far too many investors seek validation from sources that support their investment thesis, while avoiding opposing points of view. The best investors seek contrarian opinions, then evaluate the strengths of the competing arguments.
Be a "renter" not an owner. Investors often develop an unhealthy attachment to a stock. Sometimes the attachment is linked to a personal connection to the company; in other cases, investors fail to understand that a "great" company may not always be a "great" stock. Many well-managed and profitable companies become too expensive relative to earnings prospects, in other cases well-managed and profitable companies get left behind by disruptive economic forces. Facebook (ticker: FB) and Netflix ( NFLX) are considered by many to be great companies, but at current earnings multiples it is harder to consider them great stocks. Best Buy Co. ( BBY) was considered a great company for many years, but changes in retailing caused by the "Amazon" effect made Best Buy stock a laggard for much of this decade. Many successful investors think of their stocks as "rentals," which creates the emotional distance necessary to remain objective about decisions whether to sell or keep existing holdings.
Don't chase yesterday's winners. Investors typically ignore legal disclosures that past performance is not a guarantee of future performance. "Performance chasing" is a common phenomenon, with money flowing into recent winners and away from recent losers. Investors mistakenly expect recent success to continue into the future. However, performance often reverts to long-term averages, so chasing last-year's winners often leads to lagging performance and a vicious cycle of high turnover.
Beware of crowded trades. Success breeds imitation in the investment industry, and a herd of imitators can end a successful investment strategy. Quantitative investment strategies gained popularity in the early part of the 2000s, but many "quants" ended up as part of a herd that invested in the same stocks. The quant boom ended badly with the "quant quake" of 2007, as the herd headed for the exits at the same time. Popular trades have a way of becoming too popular, as investors burned by the technology bubble, the BRIC craze, and currency "carry" trades have discovered. Reversals of fortune can be particularly painful for investors who are among the last into a crowded trade! Following the herd can be a bad idea, and investors should do their homework before joining a crowded trade.
Pay more attention to detailed analysis than to stories. Humans like stories, and often create a narrative that supports their investment decisions. Midstream energy MLPs such as oil and gas pipelines became popular investments a few years ago, offering attractive historical returns, predictable cash flows, and a degree of inflation protection. When energy prices started to decline, the popular narrative was that midstream energy companies would not be vulnerable to declining prices, given long-term, volume based contracts. The "story" and reality diverged, however, as declining oil prices led to declining volumes, which in turn led to excess capacity and financial pressure throughout the oil and gas industry. Midstream energy companies felt the pain of declining energy prices, and midstream MLPs that historically were uncorrelated to energy prices suddenly had a high correlation to energy prices. It is dangerous to become captive to a thematic "story" and important to complete the research necessary to determine any flaws in the narrative.
Warren Buffett provides some valuable advice that applies to behavioral biases: be greedy when others are fearful, fearful when others are greedy. The most successful investors are aware of behavioral traps, and take steps to avoid them.
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Dan Kern is chief investment officer for TFC Financial Management, a wholly independent, fee-only, financial advisory firm based in Boston. TFC's revenues are derived solely from the fees it charges for the services it provides. Prior to joining TFC Financial Management, Dan was president and CIO of Advisor Partners. He is also a former managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds, and was managing director and principal for Montgomery Asset Management. Dan graduated from Brandeis University and earned his MBA in finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco, and sits on the board of trustees for the Green Century Funds.