By Echo Huang, CFA, CFP®, CPA
A recent study by DALBAR, a financial research firm, has confirmed that investors who try to time the stock market often dive into the market at the top and flee at the bottom. This fact has actually caused investor results to significantly lag the broader markets over the long haul.
DALBAR's most recent study shows that over the last 20 years, through December 31, 2017, the S&P 500 has produced an average annual return of 7.20%. However, over that same period, the average equity fund investor has earned only 5.29%. Bloomberg Barclays US Aggregate Bond Index has produced an average annual return of 4.98%. However, over the same period, the average fixed-income fund investor has earned only 0.44%.
Most of traditional economic and financial theory is based on the assumption that individuals will act rationally and consider all available information in their decision-making process, and that markets are efficient. Behavioral finance challenges these assumptions and explores how individuals and markets actually behave.
Emotional biases are related to feelings, perceptions, or beliefs about elements, objects, or the relations between them, and can be a function of reality or of the imagination. In the world of investing, emotions sometimes cause investors to make suboptimal decisions.
Cognitive errors, in fact, are more easily corrected than emotional biases. Cognitive errors stem from faulty reasoning, therefore better information, education and advice can often correct for them. Most cognitive biases can be “moderated” - to moderate the impact of bias is to recognize it and attempt to reduce or even eliminate it within the individual.
In this post, we'll examine the six key emotional biases, the consequences of the bias, and offer guidance on detecting and overcoming the bias. The first step is to be aware that these biases exist and then take actions to overcome them in order to have a successful investing experience.
- Endowment bias is an emotional bias in which people value an asset more when they hold rights to it than when they do not. Investors may irrationally hold on to securities they already own, a bias particularly true regarding their inherited investments. An investor may hold an inherited municipal bond portfolio due to their emotional attachment, when a more aggressive asset mix may be more appropriate.