These Biases are Hurting your Portfolio!
Updated: May 1, 2022
As financial advisors, we're constantly in pursuit to identify what variables play the largest role in achieving higher portfolio returns for our clients. Obvious guesses may be superior research & product selection, better information, right timing, etc. However, after spending a fair amount of years in the industry, I'm confident that the variable largest attributable to a client portfolio's success is behavioural/psychological. The relationships where the client and I collectively have worked towards managing behavioural biases best are the portfolios that have grossly outperformed relative to others. As Morgan Stanley's Swanand Kelkar put in his popular piece "Any superior long term return will be 80% from out-behaving, 15% from out analyzing, and if you want to be charitable, 5% from out knowing".
All humans are naturally susceptible to behavioural biases. A behavioural bias is an irrational belief that unconsciously influences our decision making process. A great example is believing that a coin flip will produce tails because it just landed five heads in a row. We know fully well that each flip comes with a 50:50 probability, yet we start believing that chances of a tails is greater this time. This is known as the gambler's fallacy. Fortunately behavioural economists have done a phenomenal job in identifying these biases over time, defining them and have given us effective defenses against them. If we are to believe Swanand Kelkar (or any successful investor for that matter), it would do us all a world of good if we spend some time understanding these biases, recognize which ones we suffer from, and take corrective action.
From anecdotal experience, I've compiled a list of biases that have persistently influenced the relationships I've worked on -
1. Confirmation Bias - this is the "tendency to search for, interpret, favor, and recall information in a way that confirms or supports one's prior beliefs or values". We've all been guilty of this. Especially when it comes to topics that evoke strong emotion e.g. politics and religion. We actively look for evidence & news that supports our existing stance often ignoring other more compelling data. Similarly while investing, we go hunting for evidence that support our existing money beliefs. These may have been formed by a multitude of factors e.g. upbringing, personal experiences, etc. I've often noticed that investors come with strong preconceived notions when it comes to equity as an asset class. An investor who's negative on equity (perhaps due to personal experience) will constantly look for reasons to avoid it. Although both the following statements are factual, this investor will always give a much larger weight to the first one;
Nifty has crashed over 20% several time since its inception
Almost no investor has lost money in Nifty over any 5 year period since inception
This investor will likely invest in safer instruments like FDs thus exposing their portfolio to a much larger and real risk i.e. loss of purchasing power.
Defense against confirmation bias - A good defense is to actively seek data, evidence, or someone who disagrees with your point of view before taking a decision.
2. Bandwagon effect (herd mentality) - the phenomenon that drives people to do something primarily because others are doing it. Herd mentality has served us well in an evolutionary manner of speaking. However, when it comes to investing it often urges us to do silly things. As the famous saying goes "nothing so undermines our financial judgement as the sight of your idiot neighbour getting rich". Herd mentality is the primary force that drives cycles of bubbles and busts. Take the Tulipmania for example. It took place in 16th century Holland where excessive speculation drove tulip prices to extremes. One tulip bulb could cost as much as today's USD 50,000-150,000! Another good example is the dotcom bubble formed around the year 2000 where obscene amounts of money was being poured in any company that had the letters ".com". We often come across products in client portfolios that are done simply because their peers have invested. Almost always the product features are completely unknown to the investor. Funnily they're also almost always responsible for the portfolio's underperformance.
Defense against the bandwagon effect - A highly effective defense against the bandwagon effect is to slow down your decision making process and make your reasoning more explicitly. Writing down the reasons before investing in a product can be a particularly good technique.
3. Recency Bias - This is the tendency to place too much emphasis on experiences/data/evidence that is freshest in your memory. Recency bias often makes us feel that recent trends will continue. What's happening in the current environment is a good example. Investors are confused and frustrated about whats happening in the markets in the last few months. Even though we all know markets can be volatile over long periods of time in theory, 2020 & 2021 made us irrationally assume a continuing upward trend. Where I've seen recency bias impact portfolios the most is the selection of stocks/mutual funds. In my experience, the CAGR is by far the most misused & misleading statistic in the entire investing universe. It plays heavily on an investor's recency bias. A typical timeline goes like this -
Fund/stock/sector/asset class gives a great return
Investor looks at past return and invests (at a high price)
Performance tapers (due to various factors)
Investor is dejected and sells (usually at a lower price)
The cycle repeats
Defense against the receny bias - Continuously go over your long term objectives & constraints. This will automatically reduce the impact of seemingly important recent events.
4. Overconfidence + Illusion of control bias - Overconfidence bias is the tendency to hold a false assessment of our skills, intellect, and talent i.e. we believe we're better than we are. The illusion of control bias usually goes hand in hand. This is when an investor tends to overestimate how much control they have over the outcome of an event. Surveys show that most people think they're above average intelligence or above average drivers. Clearly, an objective assessment of oneself is incredibly difficult. In the context of personal finance, these biases can be quite glaring in direct equity investors. They tend to grossly overestimate the performance of their stocks portfolio yet underestimate the performance of their mutual funds. This is because they mistake the ability to pick which stocks to buy/sell as having control over the outcome i.e. return. In addition to this, direct equity investors often believe their research/information is high quality or adequate. Whereas in reality, most of us have an oversimplified explanation of why we're holding a particular stock. It's almost impossible to compete with the resources and knowledge of professional fund managers who manage tens of thousand of crores.
Defense against overconfidence & illusion of control - Inviting criticism and new perspectives from professionals can be an effective deterrent. Always assume what you know is known to the entire market. It's true almost 100% of the time.
Although there are several other biases that affect our decision making process, the above will suffice for now for these are the most impactful in my opinion. Behavioural finance is a topic that's indispensable to anyone who earns, invests, and is looking to create wealth. A greater control over these biases would result in unimaginable wealth creation.