One of the most interesting areas of finance is called behavioral finance, which is the study of how our behaviors can influence the outcomes of our portfolios.
According to H. Kent Baker and Victor Ricciardi in The European Financial Review, there are several behavioral biases that can impact your investment portfolio and result in lower returns.
Here are two of those biases:
1. Representativeness
According to Baker and Ricciardi, this bias results when you label an investment “good” or “bad” based on recent performance — rather than looking at the fundamentals.
An investment might be considered “good” if its recent performance has been positive. As a result of this bias, an investor might buy something even if it’s overvalued. Representativeness encourages you to buy high. On the other hand, this bias can also cause you to overlook good deals because of a recent poor performance.
As you can see, this bias can lead to you missing out on investments that have solid growth potential, while paying too much for investments that might be at their peak.
Instead of basing investment decisions on recent performance, it’s a better idea to look at investment fundamentals to get a better idea of the true value of an investment. Look at “big picture” items such as management, balance sheet, and potential growth. You can also look at figures like P/E ratio to get an idea of whether or not the investment is overvalued or undervalued. If an asset with solid fundamentals is doing poorly in the short-term, it might actually be a good deal.
2. Familiarity
Another bias that Baker and Ricciardi tackle is familiarity, which is the idea that you prefer investments you recognize. You might choose to invest in a company you’ve heard of over one you don’t really know. Familiarity also manifests as a preference for domestic assets over foreign assets.
As a result, familiarity can lead to a lack of diversification in your portfolio. While it’s true that you should understand the assets you invest in, it’s also true that you need to go beyond a few assets. Familiarity might lead you to invest too heavily in one industry, sector, or geographical location — and you need more diversity than that for a well-balanced portfolio.
The good news is this doesn’t need to be all that risky. If you want to diversify, but are wary of foreign investments, consider using index mutual funds and ETFs. It’s possible to invest in an all-world ETF that provides you with exposure to foreign assets without as much risk or individual stock picking.
While there’s no way to completely eliminate risk from your portfolio, you can invest smarter when you’re aware of your behavioral biases. Examine your investing style for these biases, and then make changes to improve your portfolio.
Do you have either of these behavioral biases? How have you controlled them?
Editor's Note: I've begun tracking my assets through Personal Capital. I'm only using the free service so far and I no longer have to log into all the different accounts just to pull the numbers. And with a single screen showing all my assets, it's much easier to figure out when I need to rebalance or where I stand on the path to financial independence.
They developed this pretty nifty 401K Fee Analyzer that will show you whether you are paying too much in fees, as well as an Investment Checkup tool to help determine whether your asset allocation fits your risk profile. The platform literally takes a few minutes to sign up and it's free to use by following this link here. For those trying to build wealth, Personal Capital is worth a look.
{ read the comments below or add one }
The behavior that makes me lose money is listening to other people. I always tell myself to stay the course but when a friend tells me oh you should sell your stocks, i follow and then it goes up or if they tell me to buy and it goes down. That’s life I guess. I wish I had more self control.
I feel sorry for the furloughed federal workers in Washington that are suffering from the government shutdown. It’s not there fault that they’re losing money over someone else’s behavior and temper tantrum.
For people who like investing, I want to add that two attitudes that usually cause people to lose money are greed and fear.
Greed will make one to want to have it all and at the end one may lose it all. Fear prevents you from taking calculated risk. Nothing risked, nothing gained.
talk about the hypotenuse being quite perplex. LOL 🙂