Investing in financial markets successfully is inherently difficult for human beings as it generally requires disciplined adherence to an organized investment plan, investment diversification, and patience. Such discipline is difficult for investors to achieve because human beings are not in fact, rational creatures. Despite our ability to reason, plan, and think before acting, our emotions play a key role in how we behave each day.
In light of this paradox, I’ve become increasingly interested in behavioral finance, the study of how human emotions influence financial decisions. Behavioral scientists suggest that investing successfully over a long time period is difficult because of the emotions and biases we have developed over our lifetime.
Numerous studies in the field of cognitive psychology confirm that human decision processes are subject to ‘illusions’ stemming from past experiences and dispositions. These ‘illusions’, so-called biases, manifest themselves in all areas of human decision making, and thus influence everyday investor decisions. Generally, emotional and cognitive biases undermine long-term investment performance, as they can cause investors to be shortsighted and irrational in their investment decision-making.
For investors, emotional and cognitive biases can result in the following irrational actions.
- Over or under reaction to price fluctuations or news
- Relying too heavily on past trends to predict the future
- Inattention to investment fundamentals
- Overemphasis on ‘popular’ investments
We cannot cure our innate behavioral biases, but once aware of them, we can proactively work to mitigate their detrimental effects on our investment performance. Through self-awareness and an understanding of behavioral finance’s basic tenants, an investor can more objectively evaluate investment decisions, and come to more bias-free solutions.
There are multiple strategies available to investors to help improve objectivity and mitigate behavioral biases.
1. Understand the behavioral biases that influence investment decisions, and attempt to recognize them in oneself and in others.
This approach requires the most self-awareness as the investor is counting on him or herself to both understand and mitigate their inherent biases.
2. Draft and implement an Investment Policy Statement (IPS), with a clear investment time-horizon, asset allocation targets, and risk-tolerance. Return to this document when making investment decisions.
Creating an IPS is one way to hold yourself accountable to your long-term investment strategy. By monitoring your portfolio, and periodically re-balancing your investments to the targets identified in your IPS, you are continually returning to the original intent for your portfolio. This approach requires self-discipline as it may be difficult to sell off in an asset class that is tearing upwards, or to add to an asset class with more modest performance.
3. Remove emotion from investing by using quantitative analysis to evaluate investments. Have an established checklist of criteria that must be met for an investment to be implemented or exited.
This approach works best for process-oriented analytical types as it requires a deep understanding of each of your investments. Practically speaking, this approach is similar to creating an IPS in that the investor must be diligent about adhering to their previously established criteria.
4. Seek an independent opinion.
As many of our clients’ know, working with a financial advisor can help keep you on track. Talking to your advisor when you are thinking about making a change to your portfolio is helpful because he or she can bring their objective opinion to the conversation. Talking through your concerns with an advisor can help you think through the potential outcomes and how they could impact your overall financial plan.
5. Control exposure to anxiety inducing investment stimuli through setting limitations on checking investment account balances and reading financial news.
Try checking your account balances on a less-frequent, systematic basis (perhaps monthly or quarterly). This will prevent a short-term focus. Additionally, focus on reputable news sources when seeking investment information and market updates, and try to read reputable investment articles as opposed to watching investment pundits on television.
As investors we need to remember that there is nothing inherently wrong with our emotions - they help us to perceive the world around us and pick up on important information every day. In regard to our investments however, our emotions can impact our investment strategy negatively if we aren’t careful. Through self-awareness of our emotional and cognitive biases, we can hopefully improve our chances for successful long-term investment outcomes.
At Simon Quick, we seek to recognize our own biases, and thus embody a team-based approach to portfolio construction and investment research. This allows for broader perspective and opportunity to consider risk and return from several angles. In the end, we are motivated to build resilient portfolios driven by investment process and long-term return opportunities, and execution from our underlying manager allocations. If you are interested in learning more about our investment process please email firstname.lastname@example.org and we would be happy discuss further.
References & Endnotes
- Chaudhary, Amar. (2013). The Impact of Behavioral Finance in Investment Decisions and Strategies – A Fresh Approach. International Journal of Management Research and Business Strategy. 2(2), 85 – 92.
- Fuller, R. J. (2000). Behavioural Finance and The Sources of Alpha. Retrieved February 17, 2019 from http://www.fullerthaler.com/downloads/bfsoa.pdf.
- Singh, Sudir. (2012). Investor Irrationality and Self-Defeating Behavior: Insights from Behavioral Finance. The Journal of Global Business Management. 8(7), 116 – 122.
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