Do you drive a car? I’ll bet you do. In fact, I’m willing to guess that you think you’re a pretty good driver—probably above average, right? And, guess what: You’re not alone. Studies demonstrate that 80 percent of drivers believe they possess above-average skill.
But, wait… what’s wrong with this thinking? Behavioral scientists call this miscalculation “optimism bias”—the theory that someone’s confidence in his or her own judgment produces better results than objective analyses would indicate.
Similarly, the field of behavioral finance combines psychological research with established economic and financial theory to better explain why people make irrational financial decisions. Indeed, there are a series of biases economists say we humans fall prey to. How many of these traits do you observe in your own investment thinking? And how can a professional investment advisor help you overcome them?
Are you a thematic investor, beginning your search for stocks with the view that a particular market segment or company is primed for bust-out success due to some technological development or demographic shift? The danger here is that, having already drawn a conclusion, individuals will look only for data that affirms their preconceived theory. When a conclusion fits your model, what could go wrong? Plenty. Behaviorists call this “confirmation error.” And its accomplice is often a good investment story that can color our research and conclusions. “Story stocks” may become untethered from hard data, objective analysis and financial reality.
While we all, understandably, love a winning investment, we really loathe our losers. Researchers have determined that a financial loss is about two-and-a-half times as painful to us as an equivalent gain. “Loss aversion,” as behavioral scientists call it, results in investor inaction. People hold their money-losing picks, anchored to overly optimistic views, with no refinement of their analysis as facts change.
We’re also prone to think, “It’s only a ‘paper loss’ unless I sell.” Wrong. If we hold—having no better information—simply to avoid the regret of recognizing a mistake, we’re losing opportunity.
We humans are adept at identifying patterns and using mental shortcuts based on experience to make decisions. Research has found fault with this shorthand: We extrapolate our most recent experience into the future indefinitely. Researchers call this “recency bias.” They’ve demonstrated its presence in mutual funds, finding that the past year’s top-performing funds often receive the lion’s share of new monies individuals add to funds. These high-flying funds often later disappoint as they post returns similar to, or worse than, their peers’, thereby gravitating to mean performance.
We’re also prone to think, “It’s only a ‘paper loss’ unless I sell.” Wrong.
These examples of flawed investment thinking, among others identified by behavioral economists, can be kept in check with a disciplined strategy created by an advisor. When considering an advisor, you must understand this expert’s investment philosophy and the process he or she uses to execute that strategy. If it’s sound and well-reasoned, it’s likely this person has worked to mitigate emotion and flawed logic from the process.
Once you select an advisor, let him or her develop your strategy over time. Don’t be quick to judge. Over-analyzing is another behavioral bias. If you evaluate your investments too frequently, questioning individual security selection rather than examining the portfolio as a whole, you’re likely setting yourself up for emotional discomfort.
In the short term, you should focus on the discipline you’ve brought to your portfolio manifest in the advisor’s process. Over time, those who stay disciplined and put capital at risk by investing in stocks and bonds have been historically rewarded with commensurately higher returns compared with those who simply save. This is your reward. Choose to be disciplined and be patient!
This article is not intended as investment, legal, accounting or tax advice. Any opinions, recommendations or indications of past performance contained in this article may be subject to risks and uncertainties beyond the control of Hallmark Capital Management, Inc. (Hallmark) and are no guarantee of future returns. Hallmark does not guarantee or certify the accuracy, completeness or timeliness of the information presented in this article. Hallmark is an investment advisor registered with the U.S. Securities and Exchange Commission. Registration with the SEC does not imply that Hallmark or any individual providing investment advisory services on behalf of Hallmark possesses a certain level of skill or training. © Hallmark Capital Management, Inc. All rights reserved.
This article was originally published in the February/March 2016 issue of Worth.