The first article in this series focused on the importance of having the right attitude and having reachable expectations.
In this article, we look at some specific behavioral errors that cause investors to end up with substantially less in their portfolio due to self-imposed return slippage.
Slippage has also been coined “the behavioral gap” by Carl Richards.
The individual investor, also known as the retail investor, doesn’t generally see much information on behavioral mistakes because the Wall Street pitchmen promote misbehavior by priming emotions, and in the process they transfer earnings potential from your pocket to theirs. But if you look, you will find lots of information. There are some very good academic studies exploring behavior but curiously, there is also a lot from financial advisory firms that claim they can save their clients from these costly errors, but there is little evidence to support the claim. The truth is individual investors must save themselves from costly mistakes.
In doing research for this article, I found remarkable agreement in the costliest behavioral mistakes investors make, and they are all connected with attempts to time the market. The top pitfalls are:
Overconfidence: Overconfidence causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events. Does overconfidence occur in investment decision-making? It is precisely this type of task at which people show the greatest overconfidence. (Nofsinger, 2001)
Representative Heuristic: a decision-making shortcut that employs the use of past experiences to guide the decision-making process. Relying on past experiences can be beneficial and allow for quick conclusions to be reached, but when applied to unfamiliar situations, the conclusion is more often wrong than right.
There are many other behavioral pitfalls, and a relevant selection can be found in the Behavior pitfalls article in the Bogleheads wiki
References and some applicable quotes:
By avoiding behavioral mistakes, temptations, and unnecessary costs you will get your fair share. By trying to get more you run the risk of not getting more, and not even getting your fair share. It’s a bet not worth taking.
Now it’s time for perhaps the most surprising of our findings. The greatest cost of all – larger than fund fees, the tax drag, or the performance gap between passive and active funds – is the loss due to investor behavior.
Our results indicate that institutional flows are largely unaffected by the performance of the market, while retail flows are influenced strongly by past returns.
“The flows data for the whole sector indicate that the performance gap has been -0.82% per year since the start of our sample in 1992. However, this is almost entirely due to the performance gap we calculate for retail investors, that we estimate at -1.17% per year compared with only -0.27% for institutional flows.”
[Investors] trade frequently and have perverse stock selection ability, incurring unnecessary investment costs and return losses. They tend to sell their winners and hold their losers, generating unnecessary tax liabilities. Many hold poorly diversified portfolios, resulting in unnecessarily high levels of diversifiable risk, and many are unduly influenced by media and past experience. Individual investors who ignore the prescriptive advice to buy and hold low fee, well diversified portfolios, generally do so to their detriment.
We document three primary results. First, investors buy funds with strong past performance; over half of all fund purchases occur in funds ranked in the top quintile of past annual returns.Second, investors sell funds with strong past performance and are reluctant to sell their losing fund investments; they are twice as likely to sell a winning mutual fund rather than a losing mutual fund and, thus, nearly 40 percent of fund sales occur in funds ranked in the top quintile of past annual returns.Third, investors are sensitive to the form in which fund expenses are charged; though investors are less likely to buy funds with high transaction fees (e.g., broker commissions or front-end load fees), their purchases are relatively insensitive to a fund’s operating expense ratio.We argue that the representative heuristic leads investors to buy past winners, the disposition effect renders investors reluctant to sell their losers, and framing effects cause investors to react differently to various forms of fund expenses.
5. Why Investors Fail, Motley Fool
Chart from Davis Advisors showing the ‘investor behavior penalty.’ Note the example of CGM focus. This is an extremely volatile fund and it attracts performance chasers who ultimately cannot stand the roller coaster ride. Investor returns in volatile funds are lower on average than those with less volatility. Balanced funds show the best investor returns overall because the equity performance is buffered by the overall performance of the fund.
6. Chapter 22. The Behavior of Individual Investors
In financial markets, there is an adding up constraint. For every buy, there is a sell. If one investor beats the market, someone else must underperform.
Collectively, we must earn the market return before costs. The presence of exceptional investors dictates the need for subpar investors. With some notable exceptions, which we describe at the end of this section, the evidence indicates that individual investors are subpar investors.
Pittfall – Sensation Seeking: A noncompeting explanation for the excessive trading of individual investors is the simple observation that trading is entertainment and appeals to people who enjoy sensation seeking activities such as gambling.
As a technical term , “noise” refers to false signals and short-term volatility that obscure the overall trend. Therefore, “noise trading” describes the activities of an investor who makes decisions regarding buy and sell trades without the use of fundamental data. These investors generally have poor timing, follow trends, and overreact to good and bad news.
Thanks to Terrance Odean and Michael Kitces for help in researching information for this article.