The Market Minute focuses on a wide range of topics that drive your portfolio – the economy, monetary policy, your choice of investments, etc.  It’s very easy to get caught up in the glut of variables, but ultimately successful investing is about behavior. 

Behavioral biases devastate portfolios more than investors are willing to admit.  Here are a few of the most common biases investors suffer from.

Overconfidence Bias: This causes investors to overestimate the quality of their judgment.   An investor might believe they are better able to spot the next hot stock, but odds are they are not.  Several studies have shown that overconfidence bias leads investors to trade more frequently in effort to align their positions with current market conditions.  The cost of frequent trading eats into returns, and rarely are the returns big enough to make up the difference.

Confirmation Bias: This is the tendency for investors to seek information that supports their decision or thesis and avoid/ignore information that contradicts it.  For example, an investor hears about a hot stock from a friend or family member and decides to do some research.   However, investors often find all sorts of positives while glossing over the red flags in trying to “confirm” the return potential of the investment.  As a result, this bias results in a poor, one-sided decision making process. 

Escalation Bias: Some of the tendencies that lead to confirmation bias may also be associated with the phenomenon referred to as escalation bias.  This is the tendency of investors to commit more funds to a position that has gone down, “averaging down” the purchase price, instead of exiting a bad investment.  A rational investor should re-evaluate holdings that have declined for evidence of deteriorating competitive advantages or fundamentals.  If the re-evaluation does not support the investment, then it may be best to exit the position and take the loss. 

Loss Aversion Bias: Because investors feel the pain of losses more than the pleasure of gains, some will hold a losing investment for too long, even when they don’t believe in the prospect of a turnaround.  This is similar to Prospect Theory, which explains the tendency of investors to hold losing stocks too long and sell winning stocks too soon.

Illusion of Control Bias: The illusion of control bias gives investors the feeling that they can control or influence their investment outcomes because they are “pulling the trigger” on each decision.  Unfortunately, investors who are subject to the illusion of control bias constantly adjust their portfolio to reflect current market conditions, which often results in high trading costs and disappointing returns.

Anchoring Bias: This occurs when investors make a buy or sell decision based on purchase points or arbitrary price levels.  Consider a stock that traded at $100 three months ago, but now trades for $80.  Investors suffering from anchoring bias will resist selling until the price rebounds to the $100 price point it achieved three months ago.  These investors are not considering that the company may have deteriorating fundamentals and, consequently, never return to the previous price point.

Endowment Bias: When evaluating an investment, investors place a higher value on an investment they already hold than they would if they didn’t own the asset and had the potential to acquire it.  This is especially evident with real estate or an inherited stock position.

These are just a few of the many poor investor behaviors.  There are ways to avoid making these mistakes, but that will be a topic for another day.  

Thanks for reading,

Peter Lazaroff, Investment Analyst

St. Louis, MO

www.acrinv.com