RE: RE: Private placement news Three behaviors that can affect your investment performance
Robert Stammers
Forbes.com
Published Thursday, Dec. 22, 2011 8:40AM EST
Investors who are believers in the so-called efficient market hypothesis were shaken up yet again when the markets didn’t factor in all available information during the heady days of subprime lending. Indeed, they have had to cede some ground to behavioral economists who point to the role of bias in financial decisions.
The efficient market hypothesis essentially says that investors cannot beat the markets over time since stock prices are based on all available information. The concept underlies some types of passive investment strategies, and I can see certain truths in the efficient market hypothesis. However, bias can play a significant role by unconsciously affecting our decision-making.
Before you begin reviewing your investment strategies and tactics for the New Year, you may want to review some of the inherent biases that plague many individual investors: behaviors that can be hard for most investors to recognize and resolve.
Bias 1: Overconfidence
As noted in the Forbes/CFA Investment Course, confidence can easily turn into overconfidence after a few easy wins:
Many novice investors get lucky: The first few stocks they pick do extremely well. Unfortunately, they start believing in themselves. They think they have a magic touch; or worse, they think they are smarter than everyone else. This often leads to disaster….
Therefore, the wise investor not only knows how to recognize signs of overconfidence in himself (such as bragging about one’s short-term investment performance), he also knows how to apply the brakes when the signs become visible. In other words, he has learned at some point how to use reasoning to overrule his emotions.
Bias 2: Familiarity
The second bias, called familiarity bias, may cause some investors to be too concentrated on opportunities in their own countries. They are more familiar with and confident about local investment opportunities, so despite the fact that it’s much easier than in the past to diversify investments across geographies, they go with what they know and can easily understand.
Mei Wang, a professor of finance at WHU-The Otto Beisheim School of Management in Germany, says that although one should take many other considerations into account, such as tax benefits, transaction costs, and so on, investors in most countries are still substantially under-diversified, in part due to their familiarity bias.
Another example of familiarity bias is a tendency by investors to buy shares in the companies they work for. In doing so, the investor may become over-allocated to the company stock and the unsystematic risks that come from being under-diversified. Individuals that are over-allocated to company stock take the risk of having their assets and their income significantly reduced should the company go through a period of financial difficulty. To weed out familiarity bias, a good approach for the New Year would be to discuss different investing strategies than you typically use with your financial adviser and then consider employing those that are appropriate for meeting your unique financial goals.
Bias 3: Anchoring
A third and final bias I want to touch on is the idea of anchoring, or becoming fixated on past information and using that information to make inappropriate investment decisions.
When investors are influenced by this bias, they may not be able to get their mind off a particular sell-price target, even if new information is available or the investing landscape has shifted significantly. They become stuck and may even ride markets to the bottom if they cannot let go of what they think the price “should” be. Wang says, “Some cognitive biases are built into the brain.”
Know thyself
However, all three biases—the tendency to become overconfident, to go with familiar picks, and to anchor—impact both individual and professional investors. Professional investors may have more tools at their disposal for reading their own biases. For instance, a whole consulting industry has been created around the ideas of behavioral economists and teaching people to understand their own biases in investing.
Perhaps the best advice for individual investors regarding bias is this: Avoid trying to outsmart the markets and instead work to outsmart yourself. Through self-examination and reflection, learn to recognize your own biases when they rear their heads.