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To Err Is Human (Part 1)

Overcoming emotionally driven decisions is difficult, but you can set yourself up to reduce the likelihood of making these mistakes.

Risk is anything that could threaten your ability to achieve a goal. Many portfolio risks that capture our attention are those that we can’t control. How will stock market movements, changing interest rates, or the price of oil affect our investments? Investing is a probabilistic exercise. The key to increasing your odds of investment success is to make sound deci­sions. Most investors could improve their portfolio risk management by turning the spotlight on themselves and recognizing when their behavioral biases may lead to bad decisions that hurt performance.

Investors should prioritize managing portfolio risks from their behavioral biases because these risks are:

1 | Within their control

2 | Likely to occur

3 | Impactful to portfolio returns

Identify. Adapt. Overcome.

The latest CFA field guide of behavioral biases groups them into two camps: emotional and cognitive.The first step to overcoming bad investment decisions from behavioral biases is to determine which bias you’re more susceptible to.

Emotional biases stem from impulse or intuition and lead to faulty reasoning owing to the influence of feelings such as fear, greed, or remorse. These biases are more difficult to overcome than cognitive biases because it’s tough to control emotional responses to the experience of losing or making money.Cognitive errors stem from faulty information processing or recall. These are split between two types. First is belief perseverance, the tendency to irra­tionally stick with current beliefs. These decision-making errors could stem from selective exposure, perception, or retention of new information. Processing errors make up the second camp of cogni­tive errors. Instead of failing to adjust to new informa­tion, these errors come from shortcuts that we use to make decisions quickly. Cognitive errors represent the limits of the human mind and tend to be easier to correct than emotional biases.

Exhibit 1 shows the taxonomy of common behavioral biases.

All investors will exhibit some of these biases during some point in their investment career. While it’s hard to avoid these biases, it’s important to take steps to mitigate their impact. 

Managing Emotional Biases

Emotional biases are difficult to manage because they stem from impulse rather than miscalculation or interpretation of information like cognitive biases. For example, fear of pain from investment losses could lead us to sell out of the market after it crashes. This is often a poor decision because valuations are more attractive following market downturns, which can lead to better future returns. On the flip side, fear of missing out could induce counterproductive performance-chasing. The decision to buy once prices are already high is another suboptimal investing deci­sion because high prices can lead to less-attractive valuations and returns going forward. In any case, doing what you wish you would have done in the past is rarely a recipe for investment success.

Morningstar’s “Mind the Gap” study quantifies the phenomenon of investors behaving badly, likely because of emotionally fueled decisions. The latest Mind the Gap study found that the returns experi­enced by the average mutual fund investor lagged the asset-weighted return of the same funds by 1.37% annually over the past 10 years through March 2018.2 This gap is simply the fund returns that investors missed out on owing to poor investment-timing deci­sions, such as performance-chasing.

Overcoming emotionally driven decisions is difficult, but you can set yourself up to reduce the likelihood of making these mistakes. Investing to your “optimal” risk-based asset allocation isn’t useful if you can’t stick with it during rough patches in the market. Depending on your level of wealth and standard of living, emotional biases may be best managed by modifying your asset allocation. For example, you could shift toward an asset allocation that’s more conservative (for example, tilting more heavily toward bonds and away from stocks) than the risk level that you ought to be able to tolerate. The higher your level of wealth and lower your standard of living, the more cushion you have to deviate from your “optimal” asset allocation. Modifying your asset allocation to adapt to your emotional biases could improve your invest­ment outcome because you’re more likely to stick with a more conservative allocation during turbulent times.

In part 2 of this article, we will look at how to overcome the cognitive errors.

 

1Pompian, M.M. 2011. “The Behavioral Biases Of Individuals.” CFA Institute. https://www.cfainstitute.org/membership/professional-development/refresher-readings/2019/behavioral-biases-individuals

2Kinnel, R. 2019. “Mind the Gap 2018.” Morningstar. https://www.morningstar.com/lp/mind-the-gap?cid=RED_RES0002

About Author Adam McCullough, CFA

Adam McCullough, CFA  

Adam McCullough, CFA, is an Analyst on Morningstar’s Manager Research Team, covering passive strategies.