It is one thing to say that we rely upon the science of markets instead of emotion; it is quite another to prevent clients from acting out of fear in a financial panic. When asked, most investors admit that they have made costly mistakes in the past because they let their emotions get the better of them.
Every year the research firm Dalbar, Inc. conducts a widely quoted study* that tries to quantify the impact of investor behavior on real-life returns by comparing investors' earnings to the average investment (using the S&P 500 as a proxy).
The latest study looks at the 20-year period that ended Dec. 31, 2010:
Average investment return = 9.1 percent
Average equity investor return = 3.8 percent
If you had put money into an S&P 500 index fund 20 years ago and just left it there — no buying, no selling, just investing and forgetting about it — you would have earned (minus fees) about 8 percent annually.
But not all people invest that way. They trade. They watch CNBC and act on the opinions of their successful (and not so successful) friends. Despite knowing better, they give into the genetic tendency to get more of those things that give them pleasure: buy high — and get rid of things that cause them pain: sell low. Human beings are just wired that way. According to Dalbar the price the average investor pays for indulging in these behaviors has been in the neighborhood of 5% per year over the past twenty years. If accurate that cost is staggering.
You may have been exposed to the Dalbar study. Our analysis indicates that the numbers are exaggerated, but that the fact remains lost returns due to investor behavior are quite signficant. In addition, the Dalbar study does not include the opportunity cost to investors when they completely retreat to cash as a result of fear or panic. The great majority (but not all) of our clients have avoided these behavioral mistakes. We devote a portion of every meeting to education and behavioral coaching. A behavioral coach can help clients to stay disciplined and be positioned to enjoy full market returns.
It is helpful to identify the destructive cognitive and emotional tendencies that are "hard wired" into the human psyche. As your wealth manager it is our role to save you from yourself; to prevent you from following these natural tendecies. The value of this behavioral coaching alone is worth many times the amount of our fee.
A few of the more common tendencies and biases include:
The Recency Effect: the tendency to emphasize recent experience too heavily.
When you fret over the short term performance of your accounts, you are making yourself a victim of the recency effect. An investor who looks at performance every day is going to find that about half of the days are up, and half are down. An investor who looks only at the monthly statement is still seeing more volatility and noise than anything else. It is not until we look long term that we see the great potential positive returns.
If when in the middle of a bear market you become convinced that the market will continue downward, you are a victim of the recency effect. Likewise if when in the middle of a bull market you become convinced that the market will continue upward, you are a victim.
Availability Bias: the tendency to overweigh evidence that comes easily to mind.
When you find yourself being swayed by a prominent opinion or market forecast in the media, you are a victim of availability bias. When repeatedly exposed to a certain line of thinking, you are more likely to agree with it regardless of its merits.
More knowlege leads to more confidence, but not necessarily better results. For example, stock analysts who know so much about the companies they analyze have been shown to be no better at stock picking than a monkey is with a dartboard.
Gambler's Fallacy: the belief that deviations from expected behavior are likely to be evened out by opposite deviations in the future.
When you find yourself thinking: "The market is has been rising all year; it is due for a correction" you are a victim of the gambler's fallacy. When you think "this stock is so low, it can't go lower!" you are likewise a victim.
The correct answer to a question may help: Knowing that when you flip a coin there is a 50% chance it will come up tails; if you flip a coin five times and it comes up heads all five times, what is the chance that on the sixth flip it will come up tails? The answer of course is 50%. The tendency is to think that tails are "due". That is gambler's fallacy.
Herding Instinct: the hard wired tendency of social beings to find solace and protection in groups, and to conform to group behavior.
This is perhaps the most difficult emotional bias to overcome. Human beings have been conditioned from prehistory to seek protection in groups; it has been a matter of survival. To go along with the crowd is comfortable; to seperate from the crowd is painful. In fact research has show that the pain of separation registers activity in the identical part of the brain affected by physical pain!
If you find that you have a burning desire to sell your investments because everyone else is selling, you are a victim of the herding instinct.
Recency effect, Availability bias, Gambler's fallacy, and Herding instinct are not the only cognitive and emotional biases that adversely effect us; there are many more. A financial advisor who acts as a behavioral coach can develop disciplines and provide a steady hand to help you to avoid behavioral mistakes.
*Dalbar's 2010 Quantitative Analysis of Investor Behavior (QAIB) study examines real investor returns from equity, fixed income and mony market mutual funds from January 1984 through December. The study was originally conducted by DALBAR, Inc in 1984 and was the first to investigate how mutual fund investors' behaviour affects the returns they actually earn. Past performance is no guarantee of future results. Indexes cannot be invested into directly.