Behavioral Finance – A Guide to Smart Investing
In his book, Beyond Greed and Fear (Harvard Business School Press, 1999), author Hersh Shefrin describes common patterns in investor behavior. A principle behavior, he states, is that investors rely on rules of thumb, or judgments based on stereotypes.
Beware the Rule of Thumb
Traditional finance assumes that investors will make objective decisions based on unbiased data. In contrast, behavioral finance asserts that investors often rely on rules of thumb to make their decisions. Because these rules of thumb may be inaccurate, investors end up making bad decisions.
The classic faulty rule of thumb is the belief that past performance is the best indicator of future performance. Subscribers to this fallacy chase hot funds in the mistaken belief that performance over a period as short as a year indicates that a fund manager is skilled, not lucky.
Here are some more flawed rules of thumb:
Losers keep losing. If a stock in your portfolio goes down, sell it;
- Winners keep winning. Buy more of the stocks that are going up;
- Small cap stocks and foreign stocks are too risky for the average investor;
- There are stock pickers who consistently beat the market
- There are fund managers who consistently beat the market
Operating with rules of thumb like these makes it all but impossible to construct a strong portfolio, or to properly maintain it. Perhaps the most common mistake investors make is simply trading too much. They believe that investing means trying to pick the winners, and they try with great vigor.
Academic studies tell us, however, that frequent traders generally earn mediocre returns. One study was conducted by Brad Barber and Terrance Odean (”Trading is Hazardous to Your Wealth,” The Journal of Finance, April 2000). The authors looked at the trading histories of more than 66,000 investors over six years ending in 1996. They found that those that traded the most had the worst returns.
In fact, the most active traders earned average annual returns of 11.4%, while the overall market return was 17.9%. How much is that difference worth in dollar terms? Applied to a starting balance of $100,000, the lower return would cost you $77,464 over six years.
Why do investors engage in this kind of destructive behavior? Cognitive dissonance is one reason. People tend to see evidence that confirms their beliefs, while dismissing evidence to the contrary. An active investor earning an 11.4% return might conclude that she did well because her accounts grew. She ignores evidence of how much more she could have earned with a simple buy-and-hold strategy, and may even consider those who got the higher return of being greedy.
Keeping on Track
We recommend three important guidelines to avoid making common behavioral investing mistakes:
1. Create a long-term plan – and stick with it. A sound investment plan will maximize the probability of achieving your most important financial goals. The plan should spell out your long-term needs, objectives and values; define risk tolerance; establish a time horizon; determine rate-of-return objectives; describe the asset classes and investment methodology that will be used, and establish a strategic implementation plan.
The plan should be monitored and adjusted based on changes in your personal economic status or goals. Market fluctuations, hot tips, and forecasts should never drive your plan.
2. Look at the big picture. Always put performance in perspective. Individual investments should be examined not just in context of overall market returns, but also as part of the larger performance over time. The goal is to capture full market returns over a long period. You may not have positive results every quarter, but you will still be on track to achieve your financial goals.
3. Keep your costs low. Your goal should be to implement and maintain your strategy at the lowest possible cost. There are many no-load, low-fee funds out there, so why spend more on a high-fee fund?
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