As behavioral finance goes mainstream, investor behavior has become more accepted as the major influence on investment performance. So how does one become Behaviorally Smart? Dalbar research shows investment losses to individual investors due to their behavior to be an average of 8% per year over the last 30 years.
And not just limited to the investor, based on research performed by Cabot Research, professional investment managers are leaving 1% to 3% a year on the table, which is significant when you realize the size of these large portfolios. So even the professionals who use sophisticated technology and extensive research make mental errors in their decision making. After all, they are also human and have to manage their cognitive biases and emotions when under pressure.
This begs the question how can investors improve? There is no simple tonic to improved performance, as this requires wholesale behavioral change – a paradigm shift in how one engages the world around them.
Steps to Investor Improvement
- greater level of self-awareness as to why they repeat the same mistakes
- develop an investment process that provides a “check yourself before you wreck yourself” step to mitigate these blind spots.
With more than 15 years of research, DNA Behavior has learned that easily identifiable behavioral traits lead to patterns of decision-making that are then very closely aligned the structure of an investor’s portfolio. So the combination of traits and patterns makes up their financial personality style. The portfolio mirrors who they are! In fact, investors should look at their portfolio as the composition of all their decisions and not just a series of market positions.
Next, the reality is that some behavioral biases cost more than others. Based on Cabot Research (read Michael Ervolini’s book “Managing Equity Portfolios“, the top 4 ways the brain can wreck investment performance are summarized as follows:
1. Holding on to winners for too long.
Known as the Endowment Effect, the investor falls in love with a winner and loses sight of the fact that its best days are gone. There is the fear of selling the position too early and missing out on future growth.
2. Selling young winners too early.
This is attributed to Risk Aversion, resulting in the investor having fears about the future and not wanting to take the bumps in the road as the stock goes up in value.
3. Holding on to losers for too long is caused by Loss Aversion.
The investor is fearful of the pain that will be caused by taking a loss and therefore, ends up with a portfolio full of losers.
4. Not adding to winners when they take off is attributed to Regret Aversion.
This is an investor who, through fear, is hesitant in their decision-making and backs out of building the stock position as it gains momentum.
Based on your history of decision-making which of these 4 patterns has cost you the most? And remember, there are also many other behavioral biases, which coupled with these, will further contribute to reduced performance. To help you on the journey of closing the investment performance gap, start with self-awareness of your behavioral traits.
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