Investor Psychology

How Biases Affect Your Portfolio

Minimize your money-related mistakes by learning about the investing biases rooted in your experiences, background, culture, and gender.

By Bob Frick, Senior Editor

From Kiplinger's Personal Finance magazine, September 2010

If you're a young, single man from Oklahoma, and you've been burned in the stock market, you should read this column carefully. But even if you're not, read on. You can minimize money-related mistakes by learning about investing biases that are rooted in your experiences, background, culture and even gender.

A market massacre, such as the one that occurred in 2008, can have a profound effect on your investing psyche. That is especially so if you experience the disaster early in life. A study called "Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?" found that in the 1980s, younger Americans -- those who came of age during the stagnant stock market of the 1970s -- were less likely than older people to buy stocks. The younger group remained disenchanted for decades, according to the study's authors, Ulrike Malmendier, of the University of California at Berkeley, and Stefan Nagel, of Stanford University. Of course, anyone who avoided stocks starting in the early 1980s missed a monumental, 20-year bull market.

Benefit of Perspective

The study found that older Americans, who had experienced a booming stock market in the 1950s and '60s, had a different take. They saw the sluggish '70s in a broader context, so they didn't find the decade's performance so dispiriting. Attitudes about risk shifted toward the end of the 1990s. After riding the technology bubble, younger Americans were more willing to buy stocks, but older people, having experienced both bull and bear markets, were more cautious. Of course, you could learn about the market's ups and downs by reading about them in a book. But the Depression-babies study and other research conclude that over the long term, knowledge of market history doesn't influence our investing habits nearly as much as personal history.

So our experiences can mislead us. Says Fran Kinniry, a senior member of the Vanguard fund family's Investment Strategy Group: "Our brains are hard-wired for making decisions that are highly durable," or long-lasting. For example, when we use the latest Zagat guide to pick a top-notch restaurant, we can be reasonably certain it will still be good the following Saturday night, says Kinniry. But financial markets aren't as predictable, he reminds us. They tend to move in cycles.

When it comes to our hard-wiring, gender tops the list. Men, more than women, tend to be overconfident, and as a result they trade more frequently. A study titled "Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment" found that portfolios of male investors trailed those of women by an average of one percentage point per year because men tended to trade more often. What's more, single men earned 1.5 percentage points per year less than single women. The study looked at 35,000 discount-broker accounts.

Another study, titled "Patriotism in Your Portfolio," showed that regional distinctions play an important role in decision-making, too. Investors from especially patriotic regions (with citizens who are more proud to be American, more willing to fight for our country and so on) are less likely to invest in foreign stocks. (The most-patriotic states include Oklahoma and Texas.)

So how do you beat baked-in biases? Sophie Shive, an author of the patriotism study and a finance professor at the University of Notre Dame, says that a good first step is to compare the makeup of your investments with that of a well-diversified portfolio.

If you discover, for example, that excessive trading or an overly U.S.-centric portfolio is hurting your performance, you just need to ask one simple question: Do the benefits of macho trading or "buy American" outweigh the desire to make more money?

Kiplinger's is partnering with Nightly Business Report on the "Your Mind & Your Money" series, funding for which is provided by the FINRA Investor Education Foundation. For companion video reports, tune in to NBR on your local PBS channel Aug. 9 and 16.

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