Managing your portfolio has more to do with gardening than you might imagine. Over the last decade, behavioral finance studied investor psychology and identified the repeated behaviors investors make throughout market cycles. As you can probably surmise, investors tend to develop many “bad” behaviors, which are the biggest reason for underperformance over time.+
Such was the topic of an article from ARS Technica:
“There’s extensive academic literature on the risks faced by investors who are overly confident of their ability to beat the market. They tend to trade more often, even if they’re losing money doing so. They take on too much debt and don’t diversify their holdings. When the market makes a sudden lurch, they tend to overreact to it. Yet, despite all that evidence, there’s no hard data on what makes investors overconfident in the first place.”
As we discussed in “Bull Markets & Why We Repeat Our Mistakes:”
“Behavioral biases that lead to poor investment decision-making is the single largest contributor to underperformance over time. Dalbar defined nine of the irrational investment behavior biases specifically:”
- Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time. Also known as “panic selling.”
- Narrow Framing – Making decisions about one part of the portfolio without considering the effects on the total.
- Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
- Mental Accounting – Separating the performance of investments mentally to justify success and failure.
- Lack of Diversification – Believing a portfolio is diversified when it is a highly correlated pool of assets.
- Herding– Following what everyone else is doing. This leads to “buy high/sell low.”
- Regret – Not performing a necessary action due to the regret of a previous failure.
- Media Response – The media is biased to optimism to sell products from advertisers and attract view/readership.
- Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.