Avoid these common investment biases

Photo by 401kcalculator.org

By Elliot Raphaelson
Posted on February 21, 2020

Many investors have biases when they structure or make changes to their portfolios. Omar Aguilar, chief investment officer of equities and multi-asset strategies at Charles Schwab, addressed some of these biases at Schwab Impact 2019, a gathering of finance industry experts in San Diego in November. They included the following:

—Recency bias: This is the tendency to invest based on the most recent favorable performance. This can be dangerous. For example, many investors have been burned badly by investing in crypto assets, incurring losses after the market peaked. What happens in the short run does not necessarily reflect long-term trends, and it may not be consistent with long-term portfolio objectives.

—Loss aversion bias: This is the tendency to avoid short-term losses anticipating a fall in equity prices. It is impossible to predict tops and bottoms in the stock market.

It is prudent to rebalance your portfolio at least annually, to protect stock market gains. But many investors sell their equity holdings too quickly and reinvest in low-yielding investments such as CDs or money market instruments.

Then they hesitate to reinvest in equities out of fear that it is the wrong time. Many readers have told me they left the market too soon, and they hesitate to come back.

Investors who establish a stable stock-to-bond ratio that is consistent with long-term objectives, and periodically rebalance to maintain it, will have better results than those who try to guess market tops and bottoms.

—Confirmation bias: This is our tendency to seek information that reinforces beliefs rather than to look for objective information that might contradict our bias.

For example, some investors prefer to invest only in a specific sector, such as energy or precious metals, and avoid diversification. Concentration in a specific sector rarely is best for long-term performance. Most investors who develop and maintain a diversified portfolio with low costs, using index funds and exchange-traded funds (ETFs), will have more consistent results.

Unless you have true expertise in a specific market segment, look for viewpoints and associated investments that may contradict preconceived notions regarding a narrow investment focus.

—Home bias: This is the tendency to invest only in a market segment you understand. Investors need to consider sectors in which they don’t have expertise.

For example, in recent decades some of the most successful investments have been in technology and new healthcare products. I don’t have expertise in healthcare, but I have had excellent results in investing in mutual funds that contain significant holdings in that sector.

If you had avoided these sectors because you didn’t know much about them — and most investors don’t — you would have missed out on significant upside. You don’t need expertise in every market segment to be a successful investor.

The best way to do it is to invest in diversified mutual funds and ETFs that contain growth companies in a broad variety of sectors. Many of my readers have been very successful, especially over the last 10 years, by controlling their biases and investing a significant percentage of their retirement funds in diversified index common stock mutual funds and ETFs.

There is no guarantee that the next decade will be as good as the last. It is likely that there will be years in which the stock market will have negative results. However, no one can tell you with certainty when or if that will happen. The most successful investors will be those who recognize their biases and take steps to keep them under control.

My advice is pretty straightforward: Establish a long-term plan with which you are comfortable. Decide what percentage of your retirement funds you want in stocks, bonds and cash equivalents such as CDs and money market instruments. Re-balance at least once a year.

Your common stock portfolio should be diversified, whether it is in mutual funds or ETFs. Select a financial firm whose management costs are low. You don’t have to pay a financial advisor 1% or more to manage your portfolio, you don’t have to pay a front-end commission, and you can find index funds and ETFs with low annual fees. Many of these have annual fees less than 0.1%.