What’s the matter with you and why is it messing up your portfolio? The oft-cited greed and fear characteristics aren’t the only human emotions that get investors in trouble. Regardless of whether you have an IRA, 401(k) plan, or taxable brokerage account, there are a whole range of behavioral biases and traits that destroy investment returns.
In my video titled, “Why Do Individual Investors Underperform?” I talked with Terrance Odean, a Professor of Finance at the University of California at Berkley about the common behavioral problems that afflict the average investor. Much of Odean’s research focuses on the trading patterns of individual investors.
Before you can avoid counterproductive traits, you first need to be aware of what they are. All investors – even professionals – are prone to cognitive and emotional errors. Let’s analyze some of these traits.
Hindsight Bias (HB)
HB occurs when people see past events as predictors of what will happen once again. As a result, the HB person likes to extract historical data to prove the certainty of future outcomes. Unfortunately, while history sometimes rhymes, it doesn’t always repeat itself verbatim.
Here’s the problem: HB may cause investors to increase their risk by overleveraging investments that have done well in the past, but may not necessarily do well in the future. HB is a cognitive disorder.
EXAMPLE: A HB investor buys into mutual funds (Nasdaq:PPTAX) with good historical performance expecting that history will repeat itself. Sometimes it does, sometimes it doesn’t.
Status Quo Bias (SQB)
People are generally not comfortable with change and as a result they avoid making changes even if it means improvement. The SQB investor prefers to make no choices or decisions because they view it as too risky. What they fail to understand is that even the “no decision choice”, is still a decision.
People with SQB fail to explore new investment opportunities. This can include unfamiliar but important asset classes like commodities (NYSEARCA:GCC), global real estate (NYSEARCA:RWO), and TIPS (NYSEARCA:GTIP). Additionally, they tend to keep investment portfolios that may be higher risk or not precisely match their goals. SQB is classified as an emotional disorder.
EXAMPLE: The SQB investor doesn’t mind hanging on to money losing stocks (NasdaqGM:QQQ) or funds because they feel comfortable or familiar with these investments.
Regret Aversion Bias (RAB)
Have you ever been afraid to make a decision because you weren’t sure it was the right one? This is a common symptom of the RAB investor. Sometimes their indecision ends up turning into a decision of default.
Another mistake that RAB types make is they will buy an investment and hold it for too long. This can even occur with investments that have gone up in value. RAB types turn into reluctant sellers because they’re scared the investment they own will increase in value after they sell it.
People dogged by RAB frequently engage in herding behavior too. In other words, they feel safer in popular or widely held stocks, mutual funds, or ETFs in order to avoid the possibility of future regret.
Ultimately, before you can get your money right, you must first get your mind right. The ETF Profit Strategy Newsletter uses technicals, fundamentals, discipline and common sense to find opportunities that others miss.
Follow us on Twitter @ ETFguide