by Colleen Gillespie, CTFA, AIF®
We decided to dedicate this issue of the Sawston Sentinel to behavioral factors that can change the trajectory of our performance, whether that is financial, physical or social performance. We can’t discount the impact biases play, even if we’re not aware we have any. Another favorite sketch shown above from Carl Richards of Behavior Gap illustrates that how we behave has the greatest impact on our performance. In the investment policy and risk awareness questions that we require all clients to complete, we ask a few behavioral finance questions that help us understand how a client will react, or what will stress them out as they watch their balances grow or decline. What are your expectations, regrets or aversions? Are they realistic, and what will you do if these expectations do or don’t come to fruition?
When researching the subject of Behavioral Finance, I found some interesting notes in Investopedia. “For decades, psychologists and sociologists have pushed back against the theories of mainstream finance and economics, arguing that human beings are not rational utility-maximizing actors and that markets are not efficient in the real world. The field of behavioral economics arose in the late 1970s to address these issues, accumulating a wide swath of cases when people systematically behave "irrationally." The article offered a few takeaways that can be drawn when studying how behavior will impact investment performance.
- Behavioral finance asserts that rather than being rational and calculating, people often make financial decisions based on emotions and cognitive biases.
- For instance, investors often hold losing positions rather than feel the pain associated with taking a loss.
- The instinct to move with the herd explains why investors buy in bull markets and sell in bear markets.
- Behavioral finance is useful in analyzing market returns in hindsight but has not yet produced any insights that can help investors develop a strategy that will outperform in the future.
Warren Buffett has a favorite quote that states “be fearful when others are greedy and greedy when others are fearful.” This sums up herd mentality, discussed in Patrick Hoover’s article in this edition. Peter Samuelson explains other biases that we may not even realize exist yet impacts our day-to-day decision-making.
While this study is a bit dated, in 2001, Dalbar, a financial-services research firm, released a study entitled "Quantitative Analysis of Investor Behavior," which concluded that average investors (do it yourselfers) consistently fail to achieve returns that beat or even match the broader market indices. The study found that in the 17-year period to December 2000, the S&P 500 returned an average of 16.29% per year, while the typical equity investor achieved only 5.32% for the same period—a startling 9% difference! It also found that during the same period, the average fixed-income investor earned only a 6.08% return per year, while the long-term Government Bond Index reaped 11.83%.
In a 2015 follow-up of the same publication, Dalbar again concluded that average investors fail to achieve market-index returns. It found that "the average equity mutual fund investor underperformed the S&P 500 by a wide margin of 8.19%. The broader market return was more than double the average equity mutual fund investor’s return (13.69% vs. 5.50%)." Average fixed income mutual fund investors also consistently underperformed—returning 4.81% less than the benchmark bond market index.
That said, investors can be their own worst enemies. Trying to out-guess the market doesn't pay off over the long term. In fact, it often results in quirky, irrational behavior, not to mention a dent in your wealth. Implementing a strategy that is well thought out and sticking to it may help you avoid many of these common investing mistakes.
We hope you find behavioral finance as interesting as us and this focus will identify what biases or triggers you may have. Everyone has different biases and motivations. We get to know yours and have spent a great deal of time and energy realizing our own which is why we developed a disciplined investment process many years ago. We even have a PowerPoint presentation that outlines this process if you are ever interested in learning more!