I recently moderated a panel on behavioral finance for the Financial Women of San Francisco. It’s a relatively new field that barely existed when I was in business school in the late 90s. Its basic premise is that people make irrational financial decisions due to their human biases.
Some of the more well-known biases are Anchoring, Overconfidence, Herding and Loss Aversion. There is real data to prove that humans tend to make bad decisions when it comes to their investments. One of the more well-known studies, known as the Dalbar1 study, shows that the average stock investor earned 3.7% per year over the 30 years ended 12/31/2013 as compared to 11.1% for the S&P 500 index of large US stocks. This discrepancy is largely due to many of the afore-mentioned behavioral biases.
A lot of my work as a financial planner is in helping my clients recognize and resist their human tendencies that are detrimental to their investing success. For example, the Herding bias says that people like to do what others are doing. This might have been a valuable survival instinct on the African savannah, but it leads to poor investment performance. It causes investors to buy after prices have already risen and to sell when they have fallen. This is due not only to poor timing, but also to trading too frequently. As with all biases, the first step in resisting them is to recognize them. Then there are certain steps you can take to resist the tendency. In the case of the herding bias, it helps to always wait before acting as you might feel differently after a day or so. Then looking at fundamentals such as absolute and relative valuation can give a clue as to whether the investment is likely to continue to do well.
Another common bias is the Overconfidence bias. This causes people to believe that things they are more familiar with will do better. This bias causes people to own too much of their company’s stock. It also causes them to resist selling as it rises on the belief that it is worth even more. A related bias, the Anchoring bias, causes them to fixate on the prior high price of the stock when the stock price is falling (or their home price) and to think they should hold onto it until it gets back to that point even if the fundamentals have changed and it no longer warrants that price. These biases are tricky to overcome because we feel so confident in things we know. However, it helps to keep in mind that our human capital asset, which can be larger than our financial assets when we are younger is also exposed to our company’s risk. Furthermore, if you buy company stock regularly through an employee stock purchase plan (ESPP), you are constantly swimming upstream if you aren’t regularly selling company stock. It can be tempting to think you should hold for a year to get favorable tax treatment upon sale of the stock, but it only takes a small decline in the price to wipe out the tax benefit.
Working with a financial planner can help you resist these biases. In fact, a recent Vanguard study2 quantified the benefit of working with a financial advisor as adding 3% per year to an investor’s return. The biggest component of the value-added, at 1.5% per year, is from “behavioral coaching”, which relates directly to coaching clients through rough periods and helping them resist the urge to do things that might harm their long-term investment performance. This can involve convincing them to stay invested in the market after a downturn so they benefit from the recovery or guiding them to reducing their exposure to company stock through a systematic sales program.
I think the best advice for investors faced with their very human nature is to measure success in terms of progress towards important life goals instead of relative to meaningless, but oft-quoted, market indices. In the end, what is going to make you happier – living the life you envision or beating the S&P 500 index?